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



[[Page 57929]]

-----------------------------------------------------------------------

Part II





Department of the Treasury





-----------------------------------------------------------------------



Internal Revenue Service



-----------------------------------------------------------------------



26 CFR Part 1



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

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

[[Page 57930]]


-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-158080-04]
RIN 1545-BE79


Application of Section 409A to Nonqualified Deferred Compensation 
Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

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

-----------------------------------------------------------------------

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

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

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

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

SUPPLEMENTARY INFORMATION:

Background

    Section 409A was added to the Internal Revenue Code (Code) by 
section 885 of the American Jobs Creation Act of 2004, Public Law 108-
357 (118 Stat. 1418). Section 409A generally provides that unless 
certain requirements are met, amounts deferred under a nonqualified 
deferred compensation plan for all taxable years are currently 
includible in gross income to the extent not subject to a substantial 
risk of forfeiture and not previously included in gross income. Section 
409A also includes rules applicable to certain trusts or similar 
arrangements associated with nonqualified deferred compensation, where 
such arrangements are located outside of the United States or are 
restricted to the provision of benefits in connection with a decline in 
the financial health of the sponsor.
    On December 20, 2004, the IRS issued Notice 2005-1 (2005-2 I.R.B. 
274 (published as modified on January 6, 2005)), setting forth initial 
guidance with respect to the application of section 409A, and supplying 
transition guidance in accordance with the terms of the statute. Notice 
2005-1 requested comments on all aspects of the application of Section 
409A, including certain specified topics. Numerous comments were 
submitted and all were considered by the Treasury Department and the 
IRS in formulating these regulations. In general, these regulations 
incorporate the guidance provided in Notice 2005-1 and provide 
substantial additional guidance. For a discussion of the continued 
applicability of Notice 2005-1, see the Effect on Other Documents 
section of this preamble.

Explanation of Provisions

I. Definition of Nonqualified Deferred Compensation Plan

A. In General

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

B. Section 457 Plans

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

[[Page 57931]]

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

C. Arrangements With Independent Contractors

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

[[Page 57932]]

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

II. Definition of Nonqualified Deferred Compensation

A. In General

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

B. Short-Term Deferrals

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

[[Page 57933]]

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

C. Stock Options and Stock Appreciation Rights

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

[[Page 57934]]

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

[[Page 57935]]

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

[[Page 57936]]

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

D. Restricted Property

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

[[Page 57937]]

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

E. Arrangements Between Partnerships and Partners

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

F. Foreign Arrangements

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

[[Page 57938]]

arrangement would have been excluded from gross income for Federal tax 
purposes under any of these sections, if the compensation had been paid 
to the service provider at the time that the legally binding right to 
the compensation first arose or, if later, the time that the legally 
binding right was no longer subject to a substantial risk of 
forfeiture.
    The Treasury Department and the IRS understand that nonresident 
aliens may work for very limited periods in the United States. Many 
deferrals of the compensation earned by nonresident aliens for services 
rendered in the United States will not be covered by section 409A, 
because under an applicable treaty the amount of compensation deferred 
would not be includible in gross income for Federal tax purposes if 
paid at the time the legally binding right to the compensation deferred 
was no longer subject to a substantial risk of forfeiture. However, 
certain compensation earned in the United States by a nonresident alien 
might be includible in gross income under such circumstances, where 
there is no applicable treaty or where the treaty does not provide an 
exclusion. Where a nonresident alien defers such compensation earned in 
the United States under a foreign nonqualified deferred compensation 
plan--for example because the service in the United States is credited 
under the plan--the application of section 409A to the deferrals of the 
compensation subject to Federal income tax could be exceedingly 
burdensome in light of the relatively small amounts attributable to the 
service in the United States. Accordingly, these regulations adopt a de 
minimis exception, under which section 409A will not apply to an amount 
of compensation deferred under a foreign nonqualified deferred 
compensation plan for a given calendar year where the individual 
service provider is a nonresident alien for that calendar year and the 
amount deferred does not exceed $10,000.
    Commentators requested clarification of the application of section 
409A to participation by U.S. citizens and resident aliens in foreign 
plans. In this context, it should be noted that under these 
regulations, transfers that are taxable under section 402(b) of the 
Code generally are not subject to section 409A. See Sec.  1.409A-
1(b)(6) of these regulations and Notice 2005-1, Q&A-4. Such transfers 
may consist of contributions to an employees' trust, where the trust 
does not qualify under section 501(a). Many foreign plans that hold 
contributions in a trust will constitute funded plans. To the extent 
that a contribution to the trust is subject to inclusion in income for 
Federal tax purposes under section 402(b), such a contribution will not 
be subject to section 409A.
    These regulations also provide that section 409A does not override 
treaty provisions that govern the U.S. Federal taxation of 
participation in particular foreign plans. Where a treaty provides that 
amounts contributed to a foreign plan by or on behalf of a service 
provider are not subject to U.S. Federal income tax, section 409A will 
not cause such amounts to be subject to inclusion in gross income.
    Some commentators requested that any participation in a foreign 
plan be exempted from section 409A, or that only deferrals of U.S. 
source compensation income be subject to section 409A. However, with 
respect to U.S. citizens working abroad, and with respect to resident 
aliens in the United States, compensation income generally is subject 
to U.S. Federal income tax absent an applicable treaty provision. 
Accordingly, the provisions of section 409A generally are applicable to 
this type of deferred compensation. In addition, the Treasury 
Department and the IRS are concerned that providing a broad exception 
for foreign plans or foreign source income would create opportunities 
for U.S. citizens and resident aliens to avoid application of section 
409A through participation in a foreign plan, or through reallocations 
of deferrals among U.S. source and foreign source income.
    The regulations provide, however, that with respect to non-U.S. 
citizens who are not lawful permanent residents of the United States, 
amounts deferred under certain broad-based foreign retirement plans are 
not subject to section 409A. This exception is intended to allow a 
worker who is not a green card holder to continue to participate in a 
broad-based foreign retirement plan that does not comply with section 
409A without incurring adverse tax consequences due solely to the 
worker earning some income in the United States that is in some manner 
credited under the plan.
    Commentators expressed concerns as to U.S. citizens and lawful 
permanent residents working abroad, and their ability to participate in 
broad-based plans of foreign employers. Generally, these workers' 
incomes are subject to Federal income tax, including section 409A. 
However, when U.S. citizens and lawful permanent residents work abroad 
for employers who sponsor broad-based foreign retirement plans 
providing relatively low levels of retirement benefits and such plans 
are nonelective, the worker's ability to control the timing of the 
income is limited. In such cases, the concerns with respect to the 
potential manipulation of the timing of compensation income addressed 
by section 409A are also limited, and do not outweigh the 
administrative burdens that would arise if a foreign employer's failure 
to amend these plans to be consistent with the provisions of section 
409A would result in substantial adverse tax consequences to U.S. 
citizens and lawful permanent residents working abroad who are covered 
by such plans. Accordingly, an exception for foreign broad-based 
retirement plans also applies with respect to U.S. citizens and lawful 
permanent residents, but only with respect to nonelective deferrals of 
foreign earned income and only to the extent that the amount deferred 
in a given year does not exceed the amount of contributions or benefits 
that may be provided by a qualified plan under section 415 (calculated 
by treating the foreign source income as compensation for purposes of 
section 415).
    Commentators also requested that certain types of payments, 
referred to as expatriate allowances, be exempted from coverage under 
section 409A. These payments were defined broadly to include many types 
of payments to U.S. citizens working abroad, intended to put the 
service providers in substantially the same economic position as the 
service providers would have been in had the services been provided in 
the United States. One very common arrangement involves payments 
intended to compensate the service provider for any differences in tax 
rates, often referred to as tax equalization plans. With respect to 
these plans, the Treasury Department and the IRS recognize that such 
payments often must be delayed because of the need to calculate foreign 
tax liabilities after the end of the year. In addition, where the 
amounts are limited to the amounts necessary to make up for difference 
in tax rates, the potential for abuse with respect to the timing of 
compensation income is not great, since the compensation will directly 
relate to taxes that the service provider has paid to a foreign 
jurisdiction. Accordingly, these regulations exempt tax equalization 
plans from coverage under section 409A provided that the payment is 
made no later than the end of the second calendar year beginning after 
the calendar year in which the individual's U.S. Federal income tax 
return is required to be filed (including extensions) for the year to 
which the tax equalization payment relates.

[[Page 57939]]

    Other payments are not excluded from section 409A merely because 
they are denominated as expatriate allowances. The Treasury Department 
and the IRS believe that the rules provided in these regulations with 
respect to setting and meeting payment dates under a nonqualified 
deferred compensation plan will provide sufficient flexibility to 
permit arrangements involving expatriate allowances to satisfy the 
requirements of section 409A. For example, as discussed more fully 
below, these regulations generally provide that to meet the requirement 
that a payment be made upon a permissible payment event or a fixed 
date, the service recipient may make the payment by the later of the 
earliest date administratively practicable following, or December 31 of 
the calendar year in which occurs, the permissible payment event or 
fixed date. At the minimum, this should offer almost 12 months of 
flexibility with respect to a payment scheduled for January 1 of a 
calendar year. The Treasury Department and the IRS request comments, 
however, as to circumstances in which this flexibility will not be 
sufficient.
    Commentators also requested a grace period during which 
arrangements with persons who have become resident aliens during a 
calendar year may be amended to comply with the requirements of section 
409A. These regulations generally provide such relief. With respect to 
the initial year in which the service provider becomes a resident 
alien, the plan may be amended with respect to the service provider 
through the end of that year to comply with (or be excluded from 
coverage under) section 409A, including allowing the service provider 
the right to change the time and form of a payment. Provided that the 
election is made before the amount is paid or payable, initial deferral 
elections may also be made with respect to compensation related to 
services in that initial year, if the election is made by the end of 
the year or, if later, the 15th day of the third month after the 
service provider meets the requirements to be a resident alien. The 
relief generally does not extend further because a service recipient 
and service provider should reasonably anticipate the potential 
application of section 409A after the initial year in which the service 
provider attains the status of a resident alien. However, the Treasury 
Department and the IRS also recognize that there may be significant 
gaps between the years in which the service provider is treated as a 
resident alien. Accordingly, the grace period is available in a 
subsequent year, provided that the service provider has been a 
nonresident alien for at least five consecutive calendar years 
immediately preceding the year in which the service provider is again a 
resident alien.
    Commentators also requested that amounts contributed or benefits 
paid under a foreign social security system that is the subject of a 
totalization agreement be exempted from coverage under section 409A. 
Totalization agreements refer to bilateral agreements between the 
United States and foreign jurisdictions intended to coordinate coverage 
under the Social Security system in the United States and similar 
systems of the foreign jurisdictions. These agreements are intended to 
minimize the potential for application of two different employment 
taxes, and correspondingly to coordinate the benefits under the two 
different social security systems. The Treasury Department and the IRS 
believe that section 409A was not intended to apply to benefits to 
which the service provider is entitled under the foreign jurisdiction 
social security system. Accordingly, these types of plans have been 
excluded from the definition of a nonqualified deferred compensation 
plan for purposes of section 409A. Similarly, for jurisdictions not 
covered by a totalization agreement, these regulations provide that 
amounts deferred under a government mandated social security system are 
not subject to section 409A.

G. Separation Pay Arrangements

1. In General
    Many commentators requested clarification of the application of 
section 409A to plans or arrangements providing payments upon a 
termination of services, generally described as severance plans. Some 
commentators requested that all such arrangements be excluded from 
coverage under section 409A. However, section 409A(d)(1)(B) contains a 
list of welfare benefits that are specifically excluded from coverage 
under section 409A, including bona fide vacation leave, sick leave, 
compensatory time, disability pay and death benefit plans. Noticeably 
absent from this list is an exception for severance plans. This is 
particularly noteworthy because section 457(e)(11) contains the 
identical list of exclusions, with the one exception that the list of 
excluded plans under section 457(e)(11) includes severance pay plans, 
while the list of excluded plans under section 409A(d)(1)(B) does not. 
Therefore, it appears that Congress intended that severance payments 
could constitute deferred compensation under section 409A. To avoid 
confusion with other Code provisions, such as the specific exclusion 
from coverage under section 457(e)(11) for severance plans or the 
treatment of such arrangements under section 3121(v)(2), these 
regulations generally refer to such arrangements as separation pay 
arrangements.
    With respect to payments available upon a voluntary termination of 
services, there is no substantive distinction between a plan labeled a 
severance plan or separation pay plan and a nonqualified deferred 
compensation plan that provides for payments upon a separation from 
service. If, as is often the case, the service recipient reserves the 
right to eliminate such arrangement at any time, the service provider 
may not have a legally binding right to the payment until payment 
actually occurs, or such other time as the service recipient's 
discretion to eliminate the right to the payments lapses. However, as 
provided in these regulations, where such negative discretion lacks 
substantive significance, or the person granted the discretion is 
controlled by, or related to, the service provider to whom the payment 
will be made, the service provider will be considered to have a legally 
binding right to the compensation.
    Commentators requested that the exclusion from coverage under 
section 409A contained in Notice 2005-1, Q&A-19(d) for payments during 
the calendar year 2005 to non-key employees pursuant to severance plans 
that are classified as welfare plans, rather than pension plans, in 
accordance with the Department of Labor regulations, be made a 
permanent exclusion. This approach generally would be consistent with 
the regulations under section 3121(v)(2) of the Code. However, the 
Department of Labor regulations reflect different concerns with respect 
to separation pay arrangements from the concerns addressed in section 
409A. The Department of Labor regulations focus on whether an 
arrangement sufficiently resembles a retirement plan to require funding 
of the obligations under such a plan, or rather is a welfare plan that 
would not require funding. In contrast, section 409A focuses on the 
manipulation of the timing of inclusion of compensation income. 
Accordingly, these regulations do not categorically exclude these 
arrangements from coverage under section 409A, although a modified 
version of this exception has been provided, as discussed below.
    Some commentators requested that the Treasury Department and the 
IRS adopt an exclusion for all amounts

[[Page 57940]]

payable upon an involuntary separation. This request is based upon the 
position under certain other Code provisions, and stated in certain 
court cases, that payments to which an individual becomes entitled upon 
an involuntary separation from service do not constitute nonqualified 
deferred compensation. See Kraft Foods North America v. U.S., 58 Fed. 
Cl. 507 (2003); Sec.  31.3121(v)(2)-1(b)(4)(iv). As discussed above, 
the statutory language and structure of section 409A strongly suggest 
that separation pay arrangements, including arrangements providing 
separation pay upon an involuntary separation, were meant to be covered 
by section 409A. Furthermore, the Treasury Department and the IRS 
believe that section 409A was not intended to be applied so narrowly. 
Section 409A addresses the manipulation of the timing of inclusion of 
compensation. Payments due to a separation from service, regardless of 
whether voluntary or involuntary, constitute a payment of compensation. 
Accordingly, the ability to manipulate the timing of the inclusion of 
income related to the receipt of those amounts is within the scope of 
section 409A.
    Much of the discussion above relates to predetermined arrangements, 
where the right to the payment upon an involuntary termination of 
services arises as part of an arrangement covering multiple service 
providers, often covering a service provider from the time the service 
provider begins performing services. Where the separation pay 
arrangement involves an agreement negotiated with a specific service 
provider at the time of the involuntary separation from service, 
commentators asked how deferral elections could be provided that would 
meet the requirement that the election be made in the year before the 
year in which the services were performed. Commentators pointed out 
that even if the service provider does not already participate in any 
involuntary separation pay arrangement, the rule in section 
409A(a)(4)(B) that allows an initial deferral election to be made 
within 30 days of initial eligibility under a plan applies only with 
respect to services performed after the election. To address these 
concerns, these regulations provide that where separation pay due to an 
involuntary termination has been the subject of bona fide, arm's length 
negotiations, the election as to the time and form of payment may be 
made on or before the date the service provider obtains a legally 
binding right to the payment.
    The Treasury Department and the IRS recognize that separation pay 
arrangements providing for short-term payments upon an involuntary 
separation from service are common arrangements, and that compliance 
with the provisions of section 409A may be burdensome. In addition, the 
Treasury Department and the IRS recognize that where both the amount of 
the payments and the time over which such payments may be made are 
limited, these arrangements create fewer concerns with respect to 
manipulation of the timing of compensation income. Accordingly, these 
regulations generally exempt such arrangements where the entire amount 
of payments does not exceed two times the service provider's annual 
compensation or, if less, two times the limit on annual compensation 
that may be taken into account for qualified plan purposes under 
section 401(a)(17) ($210,000 for calendar year 2005), each for the 
calendar year before the year in which the service provider separates 
from service, and provided further that the arrangement requires that 
all payments be made by no later than the end of the second calendar 
year following the year in which the service provider terminates 
service. These limitations generally are consistent with the safe 
harbor under which severance plans may be treated as welfare plans 
under the applicable Department of Labor regulations, and should allow 
most of these arrangements to avoid coverage under section 409A.
    The Treasury Department and the IRS further recognize that 
separation pay arrangements often occur in the context of a window 
program, where certain groups of service providers are identified as 
being subject to a separation from service, and the service recipient 
provides the identified service providers an incentive to voluntarily 
separate from service and obtain a benefit. Although technically these 
programs involve a voluntary separation from service, these regulations 
generally treat separations due to participation in a window 
arrangement the same as arrangements with respect to involuntary 
separations from service for purposes of the exceptions to coverage 
from section 409A.
    These exclusions for separation pay are not intended to allow for 
rights to payments that would otherwise be deferred compensation 
subject to section 409A to avoid application of section 409A by being 
recharacterized as separation pay. Accordingly, the exclusions for 
separation pay do not apply to the extent the separation pay acts as a 
substitute for, or a replacement of, amounts that would otherwise be 
subject to section 409A. For example, a right to separation pay 
obtained in exchange for the relinquishment of a right to a payment of 
deferred compensation subject to section 409A will not be excluded from 
coverage under section 409A, but rather will be treated as a payment of 
the original amount of deferred compensation.
2. Treatment as a Separate Plan
    Commentators have stated that arrangements involving payments due 
to an involuntary separation often operate separately from more 
traditional types of nonqualified deferred compensation plans. In 
addition, especially in the case of agreements covering an individual, 
the involuntary separation pay agreement may involve many different 
types of payments that are of a much smaller magnitude than amounts 
deferred under other types of nonqualified deferred compensation plans. 
Commentators expressed concerns that inadvertent violations of section 
409A with respect to these unique arrangements could lead to much 
larger amounts being included in income and subject to the additional 
tax under section 409A due to the aggregation of such involuntary 
separation pay arrangements with other arrangements under the 
definition of a plan. The Treasury Department and the IRS have 
concluded that a nonqualified deferred compensation plan providing 
separation pay due to an involuntary separation from service, or 
participation in a window program, should be treated as a separate type 
of plan from account balance plans, nonaccount balance plans, and other 
types of plans (generally equity-based compensation arrangements) in 
which the service provider may participate that do not provide 
separation pay due to an involuntary separation from service, or 
participation in a window program.
3. Application of the Short-Term Deferral Rule to Separation Pay 
Arrangements
    Many commentators asked for a clarification with respect to the 
application of the short-term deferral rule to separation pay 
arrangements. The right to a payment that will only be paid upon an 
involuntary termination of services generally would be viewed as a 
nonvested right. Accordingly, an involuntary separation pay arrangement 
may be structured to meet the requirements of the short-term deferral 
exception.
    Some commentators also requested that arrangements involving rights 
to payments upon termination of services for good reason be treated as 
a right subject to a substantial risk of forfeiture. These arrangements 
are common,

[[Page 57941]]

especially following a transaction resulting in a change in control of 
the service recipient. The Treasury Department and the IRS are not 
confident that amounts payable upon a voluntary separation from 
service, and amounts payable only upon a termination of services for 
good reason, always may be adequately distinguished. Furthermore, even 
if the types of good reasons sufficient to constitute a substantial 
risk of forfeiture could be elucidated, the application of such a rule 
would involve intensive factual determinations, leaving taxpayers 
uncertain in their planning and creating a significant potential for 
abuse. Accordingly, the regulations do not treat the right to a payment 
upon a separation from service for good reason categorically as a right 
subject to a substantial risk of forfeiture. However, the Treasury 
Department and the IRS request comments as to what further guidance may 
be useful with respect to arrangements containing these types of 
provisions.
4. Reimbursement Arrangements
    Many commentators requested clarification with respect to the 
application of section 409A to reimbursement agreements, involving the 
service recipient reimbursing expenses of the terminated service 
provider. Because the promise to reimburse the former service provider 
is not contingent on the provision of any substantial services for the 
service provider, the right to the payment generally would not be 
treated as subject to a substantial risk of forfeiture. Accordingly, if 
the period in which expenses incurred will be reimbursed extends beyond 
the year in which the legally binding right arises, the right to the 
amount generally would constitute deferred compensation. The Treasury 
Department and the IRS recognize that reimbursement arrangements 
following a termination of services are common, and that requiring the 
service recipient to designate an amount at the time of the termination 
conflicts with the service recipient's desire to pay only amounts that 
the former service provider has actually incurred as an expense. 
However, a categorical exclusion for reimbursement arrangements is not 
tenable, because such an exclusion would allow for a limitless amount 
of deferred compensation to be paid without regard to the rules of 
section 409A, where such compensation took the form of the 
reimbursement of personal expenses (for example, reimbursements of home 
mortgage payments). These regulations provide that certain 
reimbursement arrangements related to a termination of services are not 
covered by section 409A, to the extent that the reimbursement 
arrangement covers only expenses incurred and reimbursed before the end 
of the second calendar year following the calendar year in which the 
termination occurs. The types of reimbursement arrangements excluded 
include reimbursements that are otherwise excludible from gross income, 
reimbursements for expenses that the service provider can deduct under 
section 162 or section 167, as business expenses incurred in connection 
with the performance of services (ignoring any applicable limitation 
based on adjusted gross income), outplacement expenses, moving 
expenses, medical expenses, as well as any other types of payments that 
do not exceed $5,000 in the aggregate during any given taxable year.
    For purposes of this provision, reimbursement arrangements include 
the provision of in-kind benefits, or direct payments by the service 
recipient to the person providing the goods or services to the 
terminated service provider, if the provision of such in-kind benefits 
or direct payments would be treated as reimbursement arrangements if 
the service provider had paid for such in-kind benefits or such goods 
or services and received reimbursement from the service recipient.

H. Split-Dollar Life Insurance Arrangements

    Commentators suggested that split-dollar life insurance 
arrangements should be excluded from the requirements of section 409A. 
However, the Treasury Department and the IRS believe that in applying 
the general definition of deferred compensation to split-dollar life 
insurance arrangements, the requirements of section 409A may apply to 
certain types of such arrangements (as described in Sec.  1.61-22). 
Split-dollar life insurance arrangements that provide only death 
benefits (as defined in these proposed regulations) to or for the 
benefit of the service provider may be excluded from coverage under 
section 409A under the exception from the definition of a nonqualified 
deferred compensation plan provided in these proposed regulations for 
death benefit plans. Also, split-dollar life insurance arrangements 
treated as loan arrangements under Sec.  1.7872-15 generally will not 
give rise to deferrals of compensation within the meaning of section 
409A, provided that there is no agreement under which the service 
recipient will forgive the related indebtedness and no obligation on 
the part of the service recipient to continue to make premium payments 
without charging the service provider a market interest rate on the 
funds advanced. However, policies structured under the endorsement 
method, where the service recipient is the owner of the policy but 
where the service provider obtains a legally binding right to 
compensation includible in income in a taxable year after the year in 
which a substantial risk of forfeiture (if any) lapses, may provide for 
a deferral of compensation. Just as a promise to transfer property in a 
future year may provide for a deferral of compensation (even though the 
transfer itself is subject to section 83), an endorsement method split-
dollar life insurance arrangement that grants the service provider a 
legally binding right to a future transfer of interests in a policy 
owned by the service recipient may provide for a deferral of 
compensation subject to section 409A. For example, where a service 
recipient enters into an endorsement method split-dollar life insurance 
arrangement with respect to a service provider, and irrevocably 
promises to pay premiums in future years, the arrangement may provide 
for a deferral of compensation within the meaning of section 409A.
    Commentators raised concerns about the impact of changes to a 
split-dollar life insurance arrangement to comply with section 409A, 
where the split-dollar life insurance arrangement was entered into on 
or before September 17, 2003, and is not otherwise subject to the 
regulations set forth in Sec.  1.61-22 (a grandfathered split-dollar 
life insurance arrangement). Pursuant to Sec.  1.61-22(j)(2), if a 
grandfathered split-dollar life insurance arrangement is materially 
modified after September 17, 2003, the arrangement is treated as a new 
arrangement entered into on the date of the modification. Commentators 
expressed concern that modifications necessary to comply with section 
409A may cause the split-dollar life insurance arrangement to be 
treated as materially modified for purposes of Sec.  1.61-22(j)(2). 
Comments are requested as to the scope of changes that may be necessary 
to comply with, or avoid application of, section 409A, and under what 
conditions those changes should not be treated as material 
modifications for purposes of Sec.  1.61-22(j)(2).

III. Definition of Plan

A. Plan Aggregation Rules

    These regulations generally retain the plan aggregation rules set 
forth in Notice 2005-1, Q&A-9. Under the notice, all amounts deferred 
under an account balance plan are treated as deferred

[[Page 57942]]

under a single plan, all amounts deferred under a nonaccount balance 
are treated as deferred under a single plan, and all amounts deferred 
under any other type of plan (generally equity-based compensation) are 
treated as deferred under a single plan. As discussed above, these 
regulations expand this rule so that all amounts deferred under certain 
separation pay arrangements are treated as a single plan. The purposes 
behind these aggregation rules are two-fold. First, because the 
provisions of section 409A are applied on an individual participant 
basis, rather than disqualifying the arrangement as to all 
participants, plan aggregation rules are necessary to implement the 
compliance incentives intended under the provision. Without such rules, 
multitudes of separate arrangements could be established for a single 
participant. Should the participant want access to an amount of cash, 
the participant would amend one or more of these separate arrangements 
and receive payments. The participant would argue that only those 
separate arrangements under which the amounts were paid failed to meet 
the requirements of section 409A and were subject to the income 
inclusion and additional tax, although in fact amounts were also 
available under the additional separate arrangements. Under that 
analysis, section 409A essentially would act as a 20 percent penalty 
required to receive a payment, similar to the haircut provisions that 
were intended to be prohibited by section 409A. The Treasury Department 
and the IRS do not believe that Congress intended that the consequences 
of section 409A could be limited in such a manner. However, the 
Treasury Department and the IRS also believe that complex plan 
aggregation rules, especially rules reliant on the particular facts and 
circumstances underlying each arrangement, would lead to unwarranted 
complexities and burdens with respect to service recipient planning and 
IRS enforcement. Accordingly, these regulations adopt rules intended to 
be simple and relatively easy to administer that retain the integrity 
of the compliance incentives inherent in the statute.
    Commentators asked whether an isolated violation of a term of an 
arrangement with respect to one participant will be treated as a 
violation of the same arrangement term with respect to other 
participants covered by the same arrangement. First, the terms of the 
arrangement with respect to each participant must be determined, based 
upon the rights the individual participant has under the plan. 
Generally, these rights will be determined based upon the written 
provisions applicable under a particular arrangement, as evidenced by a 
plan document, agreement, or some combination of documents that specify 
the terms of the contract under which the compensation is to be paid. 
However, where the terms of a plan or arrangement comply with section 
409A, but the service recipient does not follow such terms, an 
individual participant's actual rights under the arrangement may be 
unclear. Where a violation of a provision is not an isolated incident, 
or involves a number of participants or an identifiable subgroup of 
participants under the arrangement, the violation may result in a 
finding that even with respect to a participant who did not directly 
benefit from the violation, the actual terms of the arrangement differ 
from the written terms of the arrangement. For example, if a plan 
document provides for installment payments upon a separation from 
service, but participants in the arrangement repeatedly are offered the 
opportunity to receive a lump sum payment, the facts and circumstances 
may indicate that the arrangement provides for an election of a lump 
sum payment for all participants.
    An analogous analytical framework applies where the service 
recipient offers different benefits to separate participants in the 
same plan or arrangement. Under the terms of the overall arrangement, 
the service provider may grant many different types of rights, 
including some rights that would not be subject to the requirements of 
section 409A and some rights that would be subject to those 
requirements. With respect to the application of section 409A, a plan 
or arrangement is analyzed as consisting of the rights and benefits 
that have actually been granted to a particular service provider. For 
example, with respect to an equity-based omnibus plan that permits the 
grant of discounted stock options that would be subject to the 
requirements of section 409A, as well as other types of stock options 
which would be excluded from coverage under section 409A, only those 
service providers actually granted the discounted stock options will be 
treated as having deferred an amount of compensation subject to section 
409A, and then only with respect to the stock options subject to 
section 409A.

B. Written Plan Requirement

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

IV. Definition of Substantial Risk of Forfeiture

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

[[Page 57943]]

of forfeiture, unless the service provider is offered a material 
inducement to do so, such as an additional amount of compensation. 
Accordingly, these provisions will not be treated as creating a 
substantial risk of forfeiture for purposes of section 409A.

V. Initial Deferral Election Rules

A. In General

    Section 409A(a)(4)(B)(i) provides that in general, a plan must 
provide that compensation for services performed during a taxable year 
may be deferred at the participant's election only if the election to 
defer such compensation is made not later than the close of the 
preceding taxable year or at such other time as provided in 
regulations. The legislative history indicates that the taxable year to 
which the statute refers is the service provider's taxable year, as it 
indicates that the Secretary may issue guidance ``providing 
coordination rules, as appropriate, regarding the timing of elections 
in the case when the fiscal year of the employer and the taxable year 
of the individual are different.'' H.R. Conf. Rep. No. 108-755, at 732 
(2004). Accordingly, these regulations provide as a general rule that a 
service provider must make a deferral election in his or her taxable 
year before the year in which the services are performed. As discussed 
below, certain coordination rules for fiscal year employers have been 
provided.
    An election to defer an amount includes an election both as to the 
time and form of the payment. An election is treated as made as of the 
date the election becomes irrevocable. Changes may be made to an 
initial deferral election, provided that the election becomes 
irrevocable (except to the extent the plan permits a subsequent 
deferral election consistent with these regulations) no later than the 
last date that such an election may be made. Commentators had 
questioned whether an evergreen deferral election, or a deferral 
election as to future compensation that remains in place unless the 
service provider changes the election, would be effective for purposes 
of section 409A. Such an election satisfies the initial deferral 
election requirements only if the election becomes irrevocable with 
respect to future compensation no later than the last permissible date 
an affirmative initial deferral election could have been made with 
respect to such compensation. For example, with respect to a salary 
deferral program under which an employee makes an initial deferral 
election to defer 10 percent of the salary earned during the subsequent 
calendar year, a plan may provide that the deferral election remains 
effective unless and until changed by the employee, provided that with 
respect to salary earned during any future taxable year, the election 
to defer 10 percent of such salary becomes irrevocable no later than 
the December 31 of the preceding calendar year.

B. Nonelective Arrangements

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

C. Performance-Based Compensation

    Section 409A(a)(4)(B)(iii) provides that in the case of any 
performance-based compensation based on services performed over a 
period of at least 12 months, a participant's initial deferral election 
may be made no later than six months before the end of the period. The 
legislative history indicates that the performance-based compensation 
should be required to meet certain requirements similar to those under 
section 162(m), but not all requirements under that section. H.R. Conf. 
Rep. No. 108-755, at 732 (2004). An example in the legislative history, 
adopted in these regulations, is that the requirement of a 
determination by the compensation committee of the board of directors 
is not required.
    Notice 2005-1 did not provide a definition of performance-based 
compensation. Rather, Notice 2005-1, Q&A-22 provided a definition of 
bonus compensation that, until further guidance was issued, could be 
used for purposes of applying the exception to the general rule 
regarding initial deferral elections.
    Under these regulations, performance-based compensation is defined 
as compensation the payment of which or the amount of which is 
contingent on the satisfaction of preestablished organizational or 
individual performance criteria. Performance-based compensation does 
not include any amount or portion of any amount that will be paid 
either regardless of performance, or based upon a level of performance 
that is substantially certain to be met at the time the criteria are 
established.
    Performance-based compensation generally may include payments based 
upon subjective performance criteria, provided that the subjective 
performance criteria relate to the performance of the participant 
service provider, a group of service providers that includes the 
participant service provider, or a business unit for which the 
participant service provider provides services (which may include the 
entire organization), and the determination that the subjective 
performance criteria have been met is not made by the service provider 
or a member of the service provider's family, or a person the service 
provider supervises or over whose compensation the service provider has 
any control.
    Commentators requested that, similar to the provision contained in 
Sec.  1.162-27(e)(2) governing the requirements for establishing 
performance criteria for purposes of applying the deduction limitation 
under section 162(m), service recipients be allowed to establish 
performance criteria within 90 days of the commencement of a 
performance period of 12 months or more, rather than having to 
establish such criteria before the commencement of the period. These 
regulations adopt a similar provision with respect to the establishment 
of performance criteria for purposes of the exception under the 
deferral election rules, permitting the criteria to be established up 
to 90 days after the commencement of the period of service to which the 
criteria relates, provided that the outcome is not substantially 
certain at the time the criteria are established.
    The legislative history indicates that to constitute performance-
based compensation, the amount must be (1) variable and contingent on 
the satisfaction of preestablished organizational or individual 
performance criteria and (2) not readily ascertainable at the time of 
the election. H.R. Conf. Rep. No. 108-755, at 732 (2004). These 
regulations clarify that where the right to receive a specified

[[Page 57944]]

amount is itself not substantially certain, the amount is not readily 
ascertainable as the amount paid could either be the specified amount 
or zero. Accordingly, these regulations provide that at the time of the 
initial deferral election, either the amount must not be readily 
ascertainable, or the right to the amount must not be substantially 
certain. So, for example, the right to a $10,000 bonus that otherwise 
qualifies as performance-based compensation could be deferred by an 
employee up to six months before the end of the performance period, 
provided that at the time of the deferral election the employee is not 
substantially certain to meet the criteria and receive the $10,000 
payment.
    Under the definition of bonus compensation provided in Notice 2005-
1, Q&A-22, bonus compensation does not include any amount or portion of 
any amount that is based solely on the value of, or appreciation in 
value of, the service recipient or the stock of the service recipient. 
Commentators criticized this limitation as inconsistent with the 
provisions of Sec.  1.162-27 governing application of the deduction 
limitation under section 162(m), and the legislative history to section 
409A indicating that the definition of performance-based compensation 
for purposes of section 409A would be similar to that provided under 
section 162(m) and the regulations thereunder. These proposed 
regulations eliminate this limitation, so that performance-based 
compensation may be based solely upon an increase in the value of the 
service recipient, or the stock of the service recipient, after the 
date of grant or award. However, if an amount of compensation the 
service provider will receive pursuant to a grant or award is not based 
solely on an increase in the value of the stock after the grant or 
award (for example, in the case of restricted stock units or a stock 
right granted with an exercise price that is less than the fair market 
value of the stock as of the date of grant), and that other amount 
would not otherwise qualify as performance-based compensation, none of 
the compensation attributable to the grant or award is performance-
based compensation. Nonetheless, an award of equity-based compensation 
may constitute performance-based compensation if entitlement to the 
compensation is subject to a condition that would cause a non-equity-
based award to qualify as performance-based compensation, such as a 
performance-based vesting condition.
    The Treasury Department and the IRS are concerned that the 
inclusion of such amounts in the definition of performance-based 
compensation could lead to a conclusion that an election to defer 
amounts payable under a stock right will necessarily comply with 
section 409A if the initial deferral election is made at least 6 months 
before the date of exercise. However, under these proposed regulations, 
a stock right with a deferral feature is subject to section 409A from 
the date of grant. To comply with section 409A, the arrangement would 
be required to specify a permissible payment time and a form of 
payment. The requirement would not be met if, at some point during the 
term of the stock right, the stock right becomes immediately 
exercisable and the holder may decide whether and when to exercise the 
stock right. In addition, where a deferral feature is added to an 
existing stock right the stock right generally would violate section 
409A because the stock right would have a deferral feature and would 
not have specified a permissible payment time or event.

D. First Year of Eligibility

    Section 409A and these proposed regulations contain an exception to 
the general rule regarding initial deferral elections, under which a 
service provider newly eligible for participation in a plan may make a 
deferral election within the first 30 days of participation in the 
plan, provided that the election may only apply to compensation with 
respect to services performed after the election. These regulations 
further provide that for compensation that is earned based upon a 
specified performance period (for example, an annual bonus), where a 
deferral election is made in the first year of eligibility but after 
the beginning of the service period, the election is deemed to apply to 
compensation paid for service performed subsequent to the election if 
the election applies to the portion of the compensation that is no 
greater than the total amount of compensation for the performance 
period multiplied by the ratio of the number of days remaining in the 
performance period after the election over the total number of days in 
the performance period.
    Commentators had requested that the plan aggregation rules not 
apply in determining whether a service provider is newly eligible for 
participation in a plan. The concern is that a mid-year promotion, or 
management reorganization or other corporate event may make the service 
provider eligible for an arrangement that is of the same type as an 
arrangement in which the service provider already participates. For 
example, an employee participating in a salary deferral account-balance 
plan may become eligible for a bonus and a bonus deferral arrangement 
that would also be an account-balance plan.
    The Treasury Department and the IRS believe that the plan 
aggregation rules are necessary in this context. Without such a rule, 
service providers may attempt to take advantage of the new eligibility 
exception by establishing serial arrangements. For example, an employer 
may argue that a 2007 salary deferral program is a new program, and not 
a continuation of the 2006 salary deferral program. Commentators argue 
that standards should be provided comparing the terms of the two plans 
to distinguish new arrangements from those that are merely 
continuations of existing arrangements. However, such rules would by 
necessity be complicated and burdensome, generally relying on the facts 
and circumstances of the individual arrangements and resulting in 
administrative burden and uncertainties. Accordingly, these regulations 
retain the plan aggregation rules.
    However, as discussed below, certain other initial deferral 
election rules have been provided that address many of the situations 
in which service recipients desire to grant service providers the 
opportunity to make initial deferral elections due to eligibility in 
new programs. For example, the rule governing initial deferral 
elections with respect to certain forfeitable rights discussed below 
allows initial deferral elections upon eligibility for many bonus 
programs and ad hoc equity-based compensation grants. The Treasury 
Department and the IRS request comments as to whether these rules 
adequately address the concerns raised with respect to the definition 
of plan for purposes of applying the initial eligibility exception.

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

    As discussed above, an amount that is paid by the 15th day of the 
third month following the end of the first taxable year in which the 
payment is no longer subject to a substantial risk of forfeiture 
generally will not constitute a deferral of compensation. Commentators 
asked how the deferral election rules apply to an election to defer 
such an amount. Generally, once the service provider has begun 
performing the services required to vest, no election to defer could be 
made that would meet the timing requirements for initial deferral 
elections. Commentators suggested that the rules governing subsequent 
changes to the time and form of payment could be applied to elections 
to defer these

[[Page 57945]]

amounts. The regulations provide that for purposes of an election to 
defer amounts that would not otherwise be subject to section 409A due 
to the short-term deferral rule, the date the substantial risk of 
forfeiture lapses is treated as the original time of payment 
established by an initial deferral election, and the form in which the 
payment would be made absent a deferral election is treated as the 
original form of payment established by an initial deferral election. 
Accordingly, the service provider may elect to defer the payment beyond 
the time at which the payment originally was scheduled to be made, in 
accordance with the rules governing subsequent changes in the time and 
form of payment. In general, this means that the service provider must 
make the election at least 12 months before the right to the payment 
vests, and must defer the payment for a period of not less than 5 years 
from the date the right to the payment could vest. Thus, no payment 
could be made within 5 years of the date the right to the payment vests 
(including upon a separation from service), except for instances of a 
change in control of the corporation, death, disability or an 
unforeseeable emergency. This would also mean that if the right to the 
payment actually vests within 12 months of the election, and the 
election is given effect so that the payment is not made within the 
short-term deferral period, the deferral of the payment would violate 
the requirements of section 409A.
    For example, an employee may be entitled to the immediate payment 
of a bonus upon the occurrence of an initial public offering, where 
such a condition qualifies as a substantial risk of forfeiture so that 
the arrangement would constitute a short-term deferral. At some point 
after obtaining the right to the payment but before the initial public 
offering, the employee elects to defer any potential bonus payment to a 
date 5 years from the date of the initial public offering. To comply 
with the initial deferral election rules, that deferral election must 
not be given effect for 12 months. Accordingly, if the initial public 
offering occurred within 12 months of the deferral election, the 
payment must be made at the time of the initial public offering in 
accordance with the short-term deferral rules. If the payment is not 
made at such time, but rather is made, for example, 5 years from the 
date of the initial public offering, the payment would be deemed 
deferred pursuant to an invalid initial deferral election effective 
before the required lapse of 12 months and the arrangement would 
violate section 409A.

F. Initial Deferral Election With Respect to Certain Forfeitable Rights

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

G. Initial Deferral Election With Respect to Fiscal Year Compensation

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

H. Deferral Elections With Respect to Commissions

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

[[Page 57946]]

payment from which the commission is derived.

VI. Time and Form of Payment

A. In General

    The regulations incorporate the statutory requirement that payments 
be made at a fixed date or under a fixed schedule, or upon any of five 
events: a separation from service, death, disability, change in the 
ownership or effective control of a corporation (to the extent provided 
by the Secretary), or unforeseeable emergency. As requested by 
commentators, these regulations provide guidance on what it means for a 
payment to be made upon one of these events. Where the time of payment 
is based upon the occurrence of a specified event (such as one of the 
five events listed above or upon the lapse of a substantial risk of 
forfeiture as discussed below), the plan must designate an objectively 
determinable date or year following the event upon which the payment is 
to be made. For example, the plan may designate the payment date as 30 
days following a separation from service, or the first calendar year 
following a service provider's death. The Treasury Department and the 
IRS recognize that it may not be administratively feasible to make a 
payment upon the exact date or year designated. Furthermore, the 
Treasury Department and the IRS recognize that certain minimal delays 
that do not meaningfully affect the timing of the inclusion of income 
should not result in a violation of the requirements of section 409A. 
Accordingly, a payment will be treated as made upon the designated date 
if the payment is made by the later of the first date it is 
administratively feasible to make such payment on or after the 
designated date, or the end of the calendar year containing the 
designated date (or the end of the calendar year if only a year is 
designated). This relaxation of the timing rules for administrative 
necessity is not intended to provide a method for the service provider 
to further defer the payment. Accordingly, any inability to make the 
payment that is caused by an action or inaction of the service 
provider, or any person related to, or under the control of, the 
service provider, will not be treated as causing the making of the 
payment to be administratively infeasible.
    Once an event upon which a payment is to be made has occurred, the 
designated date generally is treated as the fixed date on which, or the 
fixed schedule under which, the payment is to be made (but not for 
purposes of the application of section 409A(a)(2)(B) generally 
requiring a six month delay in any payment upon a separation from 
service to a key employee of a corporation whose stock is traded on an 
established securities market). Accordingly, the recipient may change 
the time and form of payment after the event has occurred, provided 
that the change would otherwise be timely and permissible under these 
regulations. For example, a plan provides for payment of a lump sum on 
the third anniversary following a separation from service. A service 
provider has a separation from service on July 1, 2010. The July 1, 
2013, payment date is now treated as the fixed date upon which the 
payment is to be made. Accordingly, the service provider generally 
could elect to defer the time and form of payment provided that the 
election were made on or before June 30, 2012, and deferred the payment 
to at least July 1, 2018. For a discussion of the application of the 
subsequent deferral rules when only a calendar year of payment is 
specified, see section VI.B of this preamble.

B. Specified Time or Fixed Schedule of Payments

    Generally a plan will be deemed to provide for a specified time or 
fixed schedule of payments where, at the time of the deferral, the 
specific date upon which the payment or payments will be made may be 
objectively determined. As requested by commentators, these regulations 
permit plans to specify simply the calendar year or years in which the 
payments are scheduled to be made, without specifying the particular 
date within such year on which the payment will be made. Although this 
provision would be consistent with the flexibility allowed with respect 
to meeting the specified time or fixed schedule of payments 
requirement, the provision must be coordinated with the subsequent 
deferral rules. Section 409A(a)(4)(C)(iii) requires that if a plan 
permits under a subsequent election a delay in a payment or a change in 
the form of payment with respect to a payment payable at a specified 
time or a fixed schedule, the plan must require that the election be 
made not less than 12 months prior to the date of the first scheduled 
payment. Application of such a provision requires a specific date for 
the first scheduled payment. For a plan that does not designate a 
specific date, but rather only the year in which the payment is to be 
made, the first scheduled payment is deemed to be scheduled to be paid 
as of January 1 of such year for this purpose.
    Commentators asked whether a specified time or fixed schedule of 
payments could be determined based upon the date the service provider 
vests in the amount of deferred compensation, where the vesting is 
based upon the occurrence of an event. These regulations provide that a 
plan provides for payment at a specified time or fixed schedule of 
payments if the plan provides at the time of the deferral that the 
payment will be made at a date or dates that are objectively 
determinable based upon the date of the lapsing of a substantial risk 
of forfeiture, disregarding any acceleration of the vesting other than 
due to death or disability. So, for example, a plan that provides at 
the time the service provider obtains a legally binding right to the 
payment that the payment will be made in three installment payments, 
payable each December 31 following an initial public offering, where 
the condition that an initial public offering occur before the service 
provider is entitled to a payment constitutes a substantial risk of 
forfeiture, would satisfy the requirement that the plan provide for 
payments at a specified time or pursuant to a fixed schedule.

C. Separation From Service

    Section 409A(a)(2)(A)(i) provides that a plan may permit a payment 
to be made upon a separation from service as determined by the 
Secretary (except a payment to a specified employee, in which case the 
payment must be made subject to a six-month delay, discussed more fully 
below). These regulations provide guidance as to the circumstances 
under which service providers, including employees and independent 
contractors, will be treated as separating from service for purposes of 
section 409A. These rules are intended solely as guidance with respect 
to section 409A(a)(2)(A)(i), and should not be relied upon with respect 
to any other Code provisions, such as provisions with respect to 
distributions under qualified plans and provisions related to the 
service recipients' employment tax and information reporting 
obligations.
1. Employees
    These regulations provide that an employee experiences a separation 
from service if the employee dies, retires, or otherwise has a 
termination of employment with the employer. However, the employment 
relationship is treated as continuing intact while the individual is on 
military leave, sick leave, or other bona fide leave of absence (such 
as temporary employment by the Government) if the period of such leave 
does not exceed six months, or if longer, so long as the individual's 
right

[[Page 57947]]

to reemployment with the service recipient is provided either by 
statute or by contract. If the period of leave exceeds six months and 
the individual's right to reemployment is not provided either by 
statute or by contract, the employment relationship is deemed to 
terminate on the first date immediately following such six-month 
period.
    Whether the employee has experienced a termination of employment is 
determined based on the facts and circumstances. The Treasury 
Department and the IRS do not intend for this standard to allow for the 
extension of deferrals through the use of consulting agreements or 
other devices under which the service provider technically agrees to 
perform services as demanded, but for which there is no intent that the 
service provider perform any significant services. Accordingly, the 
regulations provide an anti-abuse rule stating that where an employee 
either actually or purportedly continues in the capacity as an 
employee, such as through the execution of an employment agreement 
under which the service provider agrees to be available to perform 
services if requested, but the facts and circumstances indicate that 
the employer and the service provider did not intend for the service 
provider to provide more than insignificant services for the employer, 
an employee will be treated as having a termination of employment and a 
separation from service. For these purposes, an employer and employee 
will be deemed to have intended for the employee to provide more than 
insignificant services if the employee provides services at an annual 
rate equal to at least 20 percent of the services rendered and the 
annual remuneration for such services is equal to at least 20 percent 
of the average remuneration earned during the immediately preceding 
three full calendar years of employment (or, if the employee was 
employed for less than three years, such lesser period).
    In addition, the Treasury Department and the IRS do not intend for 
this standard to be circumvented to create a separation from service 
where the service provider continues to perform significant services 
for the service recipient. For these purposes, the regulations provide 
that where an employee continues to provide services to a previous 
employer in a capacity other than as an employee, a separation from 
service will be treated as not having occurred if the former employee 
provides services at an annual rate that is 50 percent or more of the 
services rendered, on average, during the final three full calendar 
years of employment (or, if less, such lesser period) and the annual 
remuneration for such services is 50 percent or more of the average 
annual remuneration earned during the immediately preceding three full 
calendar years of employment (or if less, such lesser period).
    Commentators asked whether the previous positions of the Treasury 
Department and the IRS with respect to a separation from service for 
purposes of section 401(k), generally referred to as the same desk 
rule, would apply in these circumstances. Under that rule, in certain 
situations where the identity of the employee's employer changed, such 
as with respect to a sale of substantially all of the assets of the 
original employer to a new employer who hired the employee, the 
employee would not be treated as having a separation from service where 
the duties and responsibilities of the employee had not materially 
changed. These regulations do not incorporate this standard.
    Commentators had requested the ability to elect whether to apply 
the same desk rule in the case of a corporate transaction, such as a 
sale of substantially all of the assets of the original employer. The 
Treasury Department and the IRS do not believe that such a rule would 
be consistent with the provisions of section 409A, which generally 
restrict such control over the time and form of payment.
2. Independent Contractors
    The definition of a separation from service of an independent 
contractor in these proposed regulations generally is derived from the 
definition of severance from employment provided in Sec.  1.457-
6(b)(2). Comments are requested with respect to any changes that may be 
necessary to address issues arising under section 409A.
3. Delay for Key Employees
    Section 409A(a)(2)(B)(i) provides that payments upon a separation 
from service to a key employee of a corporation whose stock is publicly 
traded on an established securities market must be delayed at least six 
months following the separation from service. For these purposes, a key 
employee is defined in accordance with section 416(i), disregarding 
section 416(i)(5). Commentators asked for guidance on when a 
determination as to whether an individual is a key employee must be 
made. Section 416 relies upon plan year concepts, which generally are 
not relevant to the application of section 409A. In addition, the 
Treasury Department and the IRS wish to establish rules that minimize 
the administrative burden, while implementing the legislative intent. 
Accordingly, the regulations provide that the identification of key 
employees is based upon the 12-month period ending on an identification 
date chosen by the service recipient. Persons who meet the requirements 
of section 416(i)(1)(A)(i), (ii) or (iii) during that 12-month period 
are considered key employees for the 12-month period commencing on the 
first day of the 4th month following the end of the 12-month period. 
For example, if an employer chose December 31 as an identification 
date, any key employees identified during the calendar year ending 
December 31 would be treated as specified employees for the 12-month 
period commencing the following April 1. In this manner, service 
recipients generally may know in advance whether the person to whom a 
payment is scheduled to be made will be subject to the provision. In 
addition, service recipients may choose an identification date other 
than December 31, provided that the date must be used consistently and 
provided that any change in the identification date may not be 
effective for a period of at least 12 months.
    Some commentators had requested that certain types of payments, 
generally life annuities or longer-term installment payments, be 
excepted from the six-month delay requirement. The statutory language 
does not contemplate such an exception. Where an executive is aware 
that the source of funds to pay for his nonqualified deferred 
compensation are at significant risk, the executive may separate from 
service to obtain initial annuity or installment payments while such 
funds exist. Commentators argue that annuity payments or long-term 
installment payments generally would be less significant in amount. 
However, the Treasury Department and the IRS are not inclined to 
establish arbitrary limits, where such amounts may actually be quite 
significant due to the overall amount of the entire benefit, the number 
of installment payments, or the age of the participant, especially 
where the statutory language does not contemplate the creation of such 
an exception. Rather, the Treasury Department and the IRS believe that 
the provisions with respect to separation pay should provide service 
recipients the ability to provide reasonably significant amounts of 
benefits to terminating executives, that may respond to many of the 
concerns underlying the request to relax the six-month delay 
requirement.
    To meet the six-month delay requirement, a plan may provide that 
any payment pursuant to a separation of service due within the six-
month period is delayed until the end of the six-

[[Page 57948]]

month period, or that each scheduled payment that becomes payable 
pursuant to a separation from service is delayed six months, or a 
combination thereof. For example, a nonqualified deferred compensation 
plan of a corporation whose stock is publicly traded on an established 
securities market may provide that a participant is entitled to 60 
monthly installment payments upon separation from service, payable 
commencing the first day of the first month following the date of 
separation from service. To comply with the requirement of a six-month 
delay for payments to key employees, the plan may provide that in the 
case of an affected participant, the aggregate amount of the first 
seven months of installments is paid at the beginning of the seventh 
month following the date of separation from service, or may provide 
that the commencement date of the 60 months of installment payments is 
the first day of the seventh month following the date of separation 
from service, or may provide for a combination of these provisions. A 
plan may be amended to specify or change the manner in which the delay 
will be implemented, provided that the amendment may not be effective 
for at least 12 months. Because the delay requirement applies only to 
certain public corporations, a corporation or other entity not covered 
by the requirement may have failed to include a provision in its plans 
at the time the corporation is contemplating becoming a public 
corporation. These regulations provide that where the stock of the 
service recipient is not publicly traded on an established securities 
market, a plan may be amended to specify or change the manner in which 
the delay will be implemented, effective immediately upon adoption of 
the amendment. A plan may provide a service provider an election as to 
the manner in which the six-month delay is to be implemented, provided 
that such election is subject to otherwise applicable deferral election 
rules.

D. Death or Disability

    As provided in section 409A(a)(2)(A)(ii) and (iii), these 
regulations state that the death or disability of the service provider 
are permissible payment events. The regulations incorporate the 
definition of disability provided in section 409A(a)(2)(C). These 
regulations clarify that a plan that provides for a payment upon a 
disability need not provide for a payment upon all disabilities 
identified in section 409A(a)(2)(C), as long as any disability upon 
which a payment would be made is contained within the definition 
provided in section 409A(a)(2)(C). In addition, these regulations 
provide that a service recipient may rely upon a determination of the 
Social Security Administration with respect to the existence of a 
disability.

E. Change in Ownership or Effective Control of the Corporation

    The provisions defining a change in ownership or effective control 
of a corporation remain substantially unchanged from Notice 2005-1, 
Q&As-11 through 14. These provisions are based largely upon the 
discussion in the legislative history, indicating that the guidance 
should provide a similar, but more restrictive, definition of a change 
in the ownership or effective control of a corporation as compared to 
the definition used for purposes of the golden parachute provisions of 
section 280G. H.R. Conf. Rep. No. 108-755, at 730 (2004). Accordingly, 
the provisions largely mirror the regulations under section 280G, 
though the percentage changes in ownership necessary to qualify as 
permissible payment events have increased. However, unlike the golden 
parachute provisions, a change in control event may occur that does not 
relate to the entire group of affiliated corporations. Rather, the 
relevant analysis for purposes of section 409A generally is whether the 
corporation for whom the service provider performed services at the 
time of the event, the corporation or corporations liable for the 
payment at the time of the event, or a corporate majority shareholder 
of one of these corporations, experienced a change in control event.
    Commentators asked whether the provisions relating to the change in 
ownership or effective control of a corporation will be extended to 
non-corporate entities. Specifically, some commentators asked whether 
change in control provisions could be applied in the case of a 
partnership or other pass-through entity. Neither the statute nor the 
legislative history refers to a permissible distribution upon a change 
in ownership or effective control of any type of entity other than a 
corporation.
    However, the Treasury Department and the IRS plan to issue 
regulations under section 409A(a)(3) that will allow an acceleration of 
payments upon a change in the ownership of a partnership or in the 
ownership of a substantial portion of the assets of the partnership. 
Until further guidance is issued, the section 409A rules regarding 
permissible distributions upon a change in the ownership of a 
corporation (as described in proposed Sec.  1.409A-3(g)(5)(iv)) or a 
change in the ownership of a substantial portion of the assets of a 
corporation (as described in proposed Sec.  1.409A-3(g)(5)(vi)) may be 
applied by analogy to changes in the ownership of a partnership and 
changes in the ownership of a substantial portion of the assets of a 
partnership. For purposes of this paragraph, any references in proposed 
Sec.  1.409A-3(g)(5) to corporations, shareholders, and stock shall be 
treated as referring also to partnerships, partners, and partnership 
interests, respectively, and any reference to ``majority shareholder'' 
as applied by analogy to the owner of a partnership shall be treated as 
referring to a partner that (a) owns more than 50 percent of the 
capital and profits interests of such partnership, and (b) alone or 
together with others is vested with the continuing exclusive authority 
to make the management decisions necessary to conduct the business for 
which the partnership was formed. The Treasury Department and the IRS 
request comments with respect to the application of a change in control 
provision to partnerships and other non-corporate entities, as well as 
suggestions with respect to the formulation of which types of events 
should qualify and would be analogous to the corporate events described 
in the regulations.
    Commentators also raised questions regarding the application of 
section 409A to earn-out provisions where an acquirer contracts to make 
an immediate payment at the closing of the transaction with additional 
amounts payable at a later date, subject to the satisfaction of 
specified conditions. In such situations, the later payments could 
create delays in payments of compensation calculated by reference to 
the value of target corporation shares. These regulations address this 
situation by providing that compensation payable pursuant to the 
purchase by the service recipient of service recipient stock or a stock 
right held by a service provider, or payment of amounts of deferred 
compensation calculated by reference to the value of service recipient 
stock, may be treated as paid at a specified time or pursuant to a 
fixed schedule in conformity with the requirements of section 409A if 
paid on the same schedule and under the same terms and conditions as 
payments to shareholders generally pursuant to a change in the 
ownership of a corporation that qualifies as a change in control event 
or as payments to the service recipient pursuant to a change in the 
ownership of a substantial portion of a corporation's assets that 
qualifies as a change in control event, and any amounts paid pursuant 
to such a schedule and such terms and conditions will not be treated as 
violating the

[[Page 57949]]

initial or subsequent deferral election rules, to the extent that such 
amounts are paid not later than five years after the change in control 
event.

F. Unforeseeable Emergency

    The regulations contain provisions defining the types of 
circumstances that constitute an unforeseeable emergency, and the 
amounts that may be paid due to the unforeseeable emergency. Generally 
these provisions are derived directly from section 409A(a)(2)(B)(ii). 
Commentators requested that in the case of an unforeseeable emergency, 
a service provider be permitted to cancel future deferrals. This issue 
is discussed in this preamble at paragraph VII.D.

G. Multiple Payment Events

    The regulations permit a plan to provide that payments may be made 
upon the earlier of, or the later of, two or more specified permissible 
payment events or times. In addition, the regulations provide that a 
different form of payment may be elected for each potential payment 
event. For example, a plan may provide that a service provider will 
receive an installment payment upon separation from service or, if 
earlier, a lump sum payment upon death. The application of the rules 
governing changes in time and form of payment and the anti-acceleration 
rules to amounts subject to multiple payment events, is discussed 
below.

H. Delay in Payment by the Service Recipient

    Commentators noted that for certain compelling reasons, a service 
recipient may be unwilling or unable to make a payment of an amount due 
under a nonqualified deferred compensation plan. These regulations 
generally provide that in the case of payments the deduction for which 
would be limited or eliminated by the application of section 162(m), 
payments that would violate securities laws, or payments that would 
violate loan covenants or other contractual terms to which the service 
recipient is a party, where such a violation would result in material 
harm to the service recipient, the plan may provide that the payment 
will be delayed. In addition, plans may be amended to add such 
provisions, but such an amendment cannot be effective for a period of 
at least 12 months. However, if a plan is amended to remove such a 
provision with respect to amounts deferred previously, the amendment 
will constitute an acceleration of the payment. In the case of amounts 
for which the deduction would be limited or reduced by the application 
of section 162(m), these regulations require that the payment be 
deferred either to a date in the first year in which the service 
recipient reasonably anticipates that a payment of such amount would 
not result in a limitation of a deduction with respect to the payment 
of such amount under section 162(m) or the year in which the service 
provider separates from service. In the case of amounts that would 
violate loan covenants or similar contracts, or would result in a 
violation of Federal securities laws or other applicable laws, the 
arrangement must provide that the payment will be made in the first 
calendar year in which the service recipient reasonably anticipates 
that the payment would not violate the loan contractual terms, the 
violation would not result in material harm to the service recipient, 
or the payment would not result in a violation of Federal securities 
law or other applicable laws. These regulations also provide that the 
Commissioner may prescribe through guidance published in the Internal 
Revenue Bulletin other circumstances in which a plan may provide for 
the delay of a payment of a deferred amount. The Treasury Department 
and the IRS specifically request comments as to what other 
circumstances may be appropriate to include in such guidance.

I. Disputed Payments and Refusals To Pay

    In addition to situations in which a plan may delay payment due to 
certain business circumstances, commentators expressed concern about 
the possibility that a service recipient will refuse to pay deferred 
compensation when the payment is due, and whether such refusal to pay 
would result in taxation of the service provider under section 409A. 
Generally these situations will arise where either the obligation to 
make the payment, or the amount of the payment, is subject to dispute. 
But this situation may also arise where the service recipient simply 
refuses to pay. In either situation, these proposed regulations 
generally provide that the payment will be deemed to be made upon the 
date scheduled under the terms of the arrangement, provided that the 
service provider is acting in good faith and makes reasonable, good 
faith efforts to collect the amount. Factors relevant in determining 
whether a service provider is acting in good faith and making 
reasonable, good faith efforts to collect the amount include both the 
amount of the payment, or portion of a payment, in dispute, as well as 
the size of the disputed portion in relation to the entire payment. 
Although a payment may be delayed under this provision without 
violating section 409A because the service recipient refuses to make 
the payment, the payment may not be made subject to a subsequent 
deferral election because the payment was delayed. Rather, the payment 
must be made by the later of the end of the calendar year in which, or 
the 15th day of the third month following the date that, the service 
recipient and the service provider enter into a legally binding 
settlement of such dispute, the service recipient concedes that the 
full amount is payable, or the service recipient is required to make 
such payment pursuant to a final and nonappealable judgment or other 
binding decision. This paragraph is not intended to serve as a means of 
deferring payments without application of section 409A, by feigning a 
dispute or surreptitiously requesting that the service recipient refuse 
to pay the amount at the due date. Where the service provider is not 
acting in good faith, for example creating a dispute with no or tenuous 
basis, or where the service provider is not making reasonable, good 
faith efforts to collect the amount, the failure to receive the payment 
at the date originally scheduled may result in a violation of the 
permissible payment requirements. Among the factors to be considered is 
the practice of the service recipient with respect to payments of 
nonqualified deferred compensation. In addition, these regulations 
provide that the service provider is treated as having requested that a 
payment not be made, rather than the service recipient having refused 
to make such payment, where the decision that the service recipient 
will not make the payment is made by the service provider, or any 
person or group of persons under the supervision of the service 
provider at the time the decision is made.

VII. Anti-Acceleration Provision

A. In General

    Under section 409A(a)(3), a payment of deferred compensation may 
not be accelerated except as provided in regulations by the Secretary. 
Certain permissible payment accelerations were listed in Notice 2005-1, 
Q&A-15, including payments necessary to comply with a domestic 
relations order, payments necessary to comply with certain conflict of 
interest rules, payments intended to pay employment taxes, and certain 
de minimis payments related to the participant's termination of his or 
her interest in the plan. All the permissible payment accelerations 
contained in Notice 2005-1, Q&A-15, are included in these regulations.

[[Page 57950]]

B. Payments Upon Income Inclusion Under Section 409A

    These regulations provide that a plan may permit the acceleration 
of the time or schedule of a payment to a service provider to pay the 
amount the service provider includes in income as a result of the plan 
failing to meet the requirements of section 409A. For this purpose, a 
service provider will be deemed to have included the amount in income 
if the amount is timely reported on a Form W-2 ``Wage and Tax 
Statement'' or Form 1099-MISC ``Miscellaneous Income'', as appropriate.

C. Plan Terminations

    Some commentators requested that service recipients be allowed to 
retain the right to accelerate payments upon a termination of the 
arrangement, where the termination is at the discretion of the service 
recipient. A general ability of a service recipient to make such 
payments raises the potential for abuse, especially with respect to 
arrangements with individual service providers. Where a service 
provider retains sufficient influence to obtain a termination of the 
arrangement, the service recipient's discretion to terminate the plan 
in substance would mean that amounts deferred were available to the 
service provider upon demand. Such a condition would be inconsistent 
with the provisions of and legislative intent behind section 409A.
    Some commentators requested that service recipients be permitted to 
terminate arrangements where the arrangements are broad-based, covering 
a significant number of service providers. Due to concerns about 
administrability and equity, the regulations do not adopt the 
suggestion.
    Some commentators also suggested that service recipients be 
permitted to terminate arrangements due to bona fide business reasons. 
However, the Treasury Department and the IRS are not confident that 
such a standard could be applied on a consistent and coherent basis, 
leaving service recipients unable to plan with confidence and creating 
the potential for abuse. The Treasury Department and the IRS are 
considering further guidance establishing criteria or circumstances 
under which a plan could be terminated. For that purpose, these 
regulations provide authority to the Commissioner to establish such 
criteria or circumstances in generally applicable guidance published in 
the Internal Revenue Bulletin.
    These proposed regulations provide three circumstances under which 
a plan may be terminated at the discretion of the service recipient in 
accordance with the terms of the plan. The first addresses a service 
recipient that wants to cease providing a certain category of 
nonqualified deferred compensation, such as account balance plans, 
entirely. A plan may be terminated provided that all arrangements of 
the same type (account balance plans, nonaccount balance plans, 
separation pay plans or other arrangements) are terminated with respect 
to all participants, no payments other than those otherwise payable 
under the terms of the plan absent a termination of the plan are made 
within 12 months of the termination of the arrangement, all payments 
are made within 24 months of the termination of the arrangement, and 
the service recipient does not adopt a new arrangement that would be 
aggregated with any terminated arrangement under the plan aggregation 
rules at any time for a period of five years following the date of 
termination of the arrangement.
    The remaining two exceptions relate to events that are both 
objectively determinable to have occurred--and so may be determined 
consistently--and are of such independent significance that they are 
unlikely to be related to any attempt to accelerate payments under a 
nonqualified deferred compensation plan in a manner inconsistent with 
the intent of the statute. These regulations provide that during the 12 
months following a change in control of a corporation, the service 
recipient may elect to terminate a plan and make payments to the 
participants. In addition, a plan may provide that the plan terminates 
upon a corporate dissolution taxed under section 331, or with the 
approval of a bankruptcy court pursuant to 11 U.S.C. Sec.  
503(b)(1)(A), provided that the amounts deferred under the plan are 
included in the participants' gross incomes by the latest of (i) the 
calendar year in which the plan termination occurs, (ii) the calendar 
year in which the amount is no longer subject to a substantial risk of 
forfeiture, or (iii) the first calendar year in which the payment is 
administratively practicable.

D. Terminations of Deferral Elections Following an Unforeseeable 
Emergency or a Hardship Distribution

    Commentators noted that although section 409A provides that a 
service provider may receive a payment upon an unforeseeable emergency, 
there is no provision explicitly permitting or requiring the service 
provider to halt all elective deferrals to receive such a payment. In 
addition, commentators noted that to receive a hardship distribution 
under a qualified plan with a qualified cash or deferred arrangement 
under section 401(k), a participant generally would be required 
pursuant to the regulations under section 401(k) to halt any elective 
deferrals of compensation into a nonqualified deferred compensation 
plan. In response, these regulations provide that a plan may provide 
that a deferral election terminates if a service provider obtains a 
payment upon an unforeseeable emergency. Similarly, these regulations 
provide that a plan may provide that a deferral election is terminated 
if required for a service provider to obtain a hardship distribution 
under a qualified plan with a qualified cash or deferred arrangement 
under section 401(k). In each case, the deferral election must be 
terminated, and not merely suspended. A deferral election under the 
arrangement made after a termination of a deferral election due to a 
hardship distribution or an unforeseeable emergency will be treated as 
an initial deferral election.

E. Distributions To Avoid a Nonallocation Year Under Section 409(p)

    Commentators noted that in the case of an S corporation sponsoring 
an employee stock ownership plan, under certain conditions 
distributions from a nonqualified deferred compensation plan may be 
necessary to avoid a nonallocation year (within the meaning of section 
409(p)(3)). These regulations provide rules under which such 
distributions may be made to avoid such a nonallocation year.

VIII. Subsequent Changes in the Time and Form of Payment

A. In General

    Section 409A(a)(4)(C) and these regulations provide that, in the 
case of a plan that permits a service provider to make a subsequent 
election to delay a payment or to change the form of a payment 
(provided that any such payment is the subject of an initial deferral 
election), the following conditions must be met:
    (1) The plan must require that such election not take effect until 
at least 12 months after the date on which the election is made,
    (2) In the case of an election related to a payment other than a 
payment on account of death, disability or the occurrence of an 
unforeseeable emergency, the plan requires that the first payment with 
respect to which such election is made be deferred for a period of not 
less than 5 years from the date such payment would otherwise have been 
made (the 5-year rule), and

[[Page 57951]]

    (3) The plan requires that any election related to a payment at a 
specified time or pursuant to a fixed schedule may not be made less 
than 12 months prior to the date of the first scheduled payment.

B. Definition of Payment

    Commentators requested clarification whether the individual amounts 
paid in a defined stream of payments, such as installment payments, are 
treated as separate payments or as one payment. This affects the 
application of the rules governing subsequent deferral elections, 
particularly the 5-year rule.
    These proposed regulations provide generally that each separately 
identified amount to which a service provider is entitled to payment 
under a plan on a determinable date is a separate payment. Accordingly, 
if an amount is separately identified as a payment, either because the 
right arises under a separate arrangement or because the arrangement 
identifies the amount as a separate payment, the amount will not be 
aggregated with other amounts for purposes of the rules relating to 
subsequent changes in the time and form of payment and the anti-
acceleration rule. For example, an arrangement may provide that 50 
percent of the benefit is paid as a lump sum at separation from 
service, and that the remainder of the benefit is paid as a lump sum at 
age 60, which would identify each amount as a separate payment. 
However, once a payment has been identified separately, the payment may 
only be aggregated with another payment if the aggregation would 
otherwise comply with the rules relating to subsequent changes in the 
time and form of payment and the anti-acceleration rule.
    The Treasury Department and the IRS recognize that most taxpayers 
view the ability to elect installment payments as a choice of a single 
form of payment. Accordingly, the entitlement to a series of 
installment payments under a particular arrangement generally is 
treated as a single payment for purposes of the subsequent deferral 
rules. However, taxpayers could also view each individual payment in 
the series of payments as a separate payment. Accordingly, these 
regulations provide that an arrangement may specify that a series of 
installment payments is to be treated as a series of separate payments.
    An installment payment must be treated consistently both with 
respect to the rules governing subsequent changes in the time and form 
of payment, and with respect to the anti-acceleration rules. For 
example, if a 5-year installment payment is treated as a single payment 
and is scheduled to commence on July 1, 2010, then consistent with the 
5-year rule a service provider generally could change the time and form 
of the payment to a lump sum payment on July 1, 2015, provided the 
other conditions related to a change in the time and form of payment 
were met. In contrast, if a 5-year installment payment is designated as 
five separate payments scheduled for the years 2010 through 2014, then 
the service provider could not change the time and form of the payment 
to a lump sum payment to be made on July 1, 2015 because the separate 
payments scheduled for the years 2011 through 2014 would not have been 
deferred at least 5 years. Rather, the service provider generally could 
change the time and form of payment to a lump sum payment only if the 
payment were scheduled to occur no earlier than 2019 (5 years after the 
last of the originally scheduled payments).
    One exception to this rule is a life annuity, the entitlement to 
which is treated as a single payment. The Treasury Department and the 
IRS believe that taxpayers generally view an entitlement to a life 
annuity as a single form of payment, rather than a series of separate 
payments. In addition, treating a life annuity as a series of payments 
would lead to difficulty in applying the rules governing subsequent 
changes in the time and form of payment, because the aggregate amount 
of the payments and the duration of the payments are unknown, as their 
continuation depends on the continued life of the service provider or 
other individual. For example, if a single life annuity were treated as 
a series of separate payments, an election to change a form of payment 
to a lump sum payment could be made only if the lump sum payment were 
deferred to a date no earlier than five years after the death of the 
participant.

C. Application to Multiple Payment Events

    As discussed above, a plan may provide that a payment will be made 
upon the earlier of, or the later of, multiple specified permissible 
payment events. In addition, a plan may provide for a different form of 
payment depending upon the payment event. For example, a plan may 
provide that a service provider is entitled to an annuity at age 65 or, 
if earlier, a lump sum payment upon separation from service.
    The question then arises as to how the provisions governing changes 
in the time and form of payment and the anti-acceleration provision 
apply where there are multiple potential payment events, and possibly 
multiple forms of payment as well. The regulations provide that these 
provisions are to apply to each payment event separately. In the 
example above, these provisions would apply separately to the 
entitlement to the installment payment at age 65, and the entitlement 
to the lump sum payment at separation from service. Accordingly, the 
service provider generally would be able to delay the annuity payment 
date subject to the rules governing changes in the time and form of 
payment, while retaining a separate right to receive a lump sum payment 
at separation from service if that occurred at an earlier date. In 
other words, the 5-year rule would apply to the annuity payment date 
(delaying payment from age 65 to at least age 70) but not to the 
unchanged lump sum payment available upon separation from service 
before age 70.
    Similarly, a plan may provide that an intervening event that is a 
permissible payment event under section 409A may override an existing 
payment schedule already in payment status. For example, a plan could 
provide that a participant would receive six installment payments 
commencing at separation from service, but also provide that if the 
participant died after the payments commenced, all remaining benefits 
would be paid in a lump sum.
    An additional question arises where a new payment event, or a fixed 
time or fixed schedule of payments, is added to the plan. Generally, 
the addition of the payment event or date will be subject to the rules 
governing changes in the time and form of payment and the anti-
acceleration rules. Accordingly, no fixed time of payment could be 
added that did not defer the payment at least five years from the date 
the fixed time was added. In addition, no payment due to any other 
added permissible event could be made within five years of the addition 
of the event. For example, a service provider entitled to a payment 
only on January 1, 2050, could not make a subsequent deferral election 
to be paid on the later of January 1, 2050, or separation from service, 
but could make a subsequent deferral election to be paid at the later 
of separation from service or January 1, 2055.

IX. Application of Rules to Nonqualified Deferred Compensation Plans 
Linked to Qualified Plans

A. In General

    Commentators raised many issues concerning the application of 
section 409A to nonqualified deferred compensation plans linked to 
qualified plans. These linked plans exist in a variety of formats, and 
are referred to

[[Page 57952]]

under various labels such as excess plans, wrap plans, and supplemental 
employee retirement plans (SERPs). Typically the purpose of such plans 
is to replace the benefits that would have been provided under the 
qualified plan absent the application of certain limits contained in 
the Code (for example, section 415, section 401(a)(17) or section 
402(g)). Often the amounts deferred under the nonqualified deferred 
compensation plan are established through an offset formula, where the 
amount deferred equals an amount determined under a formula, offset by 
any benefits credited under the qualified plan. Because of the close 
relationship between the qualified plan and the nonqualified deferred 
compensation plan, sponsor and participant actions under the qualified 
plan may affect the calculation or payment of the amounts deferred 
under the nonqualified deferred compensation plan. Commentators asked 
for guidance regarding the circumstances under which an action (or 
failure to act) under the qualified plan may be treated as violating 
section 409A, to the extent the action (or failure to act) also affects 
the amounts deferred under the nonqualified deferred compensation plan.
    These proposed regulations generally adopt rules under which 
nonqualified deferred compensation plans linked to qualified plans may 
continue to operate, though certain changes may be required. The intent 
of these rules generally is to permit the qualified plan to be 
established, amended and operated under the rules governing qualified 
plans, without causing the linked nonqualified deferred compensation 
plan to violate the rules of section 409A. However, the relief provided 
under certain rules to accommodate the linked plan structure is not 
intended to relax the rules generally with respect to all of the 
amounts deferred under the nonqualified deferred compensation plan, 
simply because a limited portion of the amounts deferred may be 
affected by actions under the qualified plan. Accordingly, in certain 
circumstances the relief provided relates solely to amounts deferred 
under the nonqualified deferred compensation plan that do not exceed 
the applicable limit on the qualified plan benefit for the taxable 
year.

B. Actions That Do Not Constitute Deferral Elections or Accelerations

    Where amounts deferred under a nonqualified deferred compensation 
plan are linked to the benefits under a qualified plan, certain 
participant actions taken with respect to the benefit accrued under the 
qualified plan may affect the amounts deferred under the nonqualified 
deferred compensation plan. Where the amounts deferred under the 
nonqualified deferred compensation plan increase, the issue is whether 
the action taken with respect to the benefit accrued under the 
qualified plan constitutes a deferral election. Where the amounts 
deferred under the nonqualified deferred compensation plan decrease, 
the issue is whether the action taken with respect to the benefit 
accrued under the qualified plan constitutes an impermissible 
acceleration of a payment under the nonqualified deferred compensation 
plan.
    With respect to the benefits provided under the qualified plan, 
these regulations provide generally that neither the amendment of the 
qualified plan to increase or decrease such benefits under the 
qualified plan nor the cessation of future accruals under the qualified 
plan is treated as a deferral election or an acceleration of a payment 
under the nonqualified deferred compensation plan. Similarly, the 
addition, removal, increase or reduction of a subsidized benefit or 
ancillary benefit under the qualified plan, or a participant election 
with respect to a subsidized benefit or ancillary benefit under the 
qualified plan, will not constitute either a deferral election or an 
acceleration of a payment under the nonqualified deferred compensation, 
even where such action results in an increase or decrease in amounts 
deferred under the nonqualified deferred compensation plan.
    Additional relief is provided with respect to nonqualified deferred 
compensation plans linked to defined contribution plans that include a 
401(k) or similar cash or deferred arrangement. Specifically, the 
regulations provide that a service provider's action or inaction under 
a qualified plan that is subject to section 402(g), including an 
adjustment to a deferral election under such qualified plan, will not 
be treated as either a deferral election or an acceleration of a 
payment under the linked nonqualified deferred compensation plan, 
provided that for any given calendar year, the service provider's 
actions or inactions under the qualified plan do not result in an 
increase in the amounts deferred under all nonqualified deferred 
compensation plans in which the service provider participates in excess 
of the limit with respect to elective deferrals under section 402(g) in 
effect for the year in which such actions or inactions occur. The 
Treasury Department and the IRS intend for this provision to address 
common arrangements whereby the amounts deferred under the nonqualified 
deferred compensation plan are linked to amounts deferred under a 
401(k) arrangement (often referred to as 401(k) wrap plans), but only 
to the extent the amount of affected deferrals under the nonqualified 
deferred compensation plan does not exceed the maximum amount that ever 
could have been electively deferred under the qualified plan.
    Similar relief is provided with respect to plans involving matching 
contributions. The regulations provide that a service provider's action 
or inaction under a qualified plan with respect to elective deferrals 
or after-tax contributions by the service provider to the qualified 
plan that affects the amounts that are credited under a nonqualified 
deferred compensation arrangement as matching amounts or other amounts 
contingent on service provider elective deferrals or after-tax 
contributions will not be treated as either a deferral election or an 
acceleration of payment, provided that such matching or contingent 
amounts, as applicable, are either forfeited or never credited under 
the nonqualified deferred compensation arrangement in the absence of 
such service provider's elective deferral or after-tax contribution, 
and provided the service provider's actions or inactions under the 
qualified plan do not result in an increase or decrease in the amounts 
deferred under all nonqualified deferred compensation plans in which 
the service provider participates in excess of the limit with respect 
to elective deferrals under section 402(g) in effect for the year in 
which such actions or inactions occur. Although the section 402(g) 
limit applies to elective deferrals, rather than matching 
contributions, the Treasury Department and the IRS believe that 
matching contributions in excess of 100 percent of the elective 
deferrals of pre-tax contributions or after-tax contributions will be 
rare.

X. Statutory Effective Dates

A. Effective Dates--Earned and Vested Amounts

    Consistent with Notice 2005-1, Q&A-16, these regulations provide 
that an amount is considered deferred before January 1, 2005, and thus 
is not subject to section 409A, if the service provider had a legally 
binding right to be paid the amount and the right to the amount was 
earned and vested as of December 31, 2004. For these purposes, a right 
to an amount is earned and vested only if the amount is not subject to 
either a substantial risk of forfeiture or a

[[Page 57953]]

requirement to perform further services. Some commentators questioned 
the application of section 409A to contractual arrangements entered 
into before the enactment of the statute. However, the statutory 
effective date is tied to the date the amount is deferred and the 
legislative history states that for these purposes, ``an amount is 
considered deferred before January 1, 2005, if the amount is earned and 
vested before such date.'' H.R. Conf. Rep. No. 108-755, at 737 (2004). 
Accordingly, these regulations are consistent with the legislative 
intent that deferred amounts that were not earned, or were not vested, 
as of December 31, 2004, are subject to the provisions of section 409A.
    Clarification has been provided with respect to when a stock right 
or similar right to compensation will be treated as earned and vested. 
The issue arises because often a stock right terminates upon a 
separation from service. Taxpayers questioned whether this meant that 
the right had not been earned and vested, because future services would 
be required to retain the right. These regulations clarify that a stock 
right or similar right will be treated as earned and vested by December 
31, 2004, if on or before such date the right was either immediately 
exercisable for a payment of cash or substantially vested property, or 
was not forfeitable. Accordingly, stock options that on or before 
December 31, 2004, were immediately exercisable for substantially 
vested stock generally would not be subject to section 409A. In 
contrast, a nonstatutory stock option that was immediately exercisable 
on or before December 31, 2004, but only for substantially nonvested 
stock, generally would be subject to section 409A.

B. Effective Dates--Calculation of Grandfathered Amount

    For account balance plans and plans that are neither account 
balance plans nor nonaccount balance plans (generally equity-based 
compensation), these regulations generally retain the method of 
calculating the grandfathered amount set forth in Notice 2005-1, Q&A 
16. Accordingly, for account balance plans the grandfathered amount 
generally will equal the vested account balance as of December 31, 
2004, plus any earnings with respect to such amounts. For equity-based 
compensation, the grandfathered amount generally will equal the payment 
that would be available if the right were exercised on December 31, 
2004, and any earnings with respect to such amount. For this purpose, 
the earnings generally would include the increase in the payment 
available due to appreciation in the underlying stock.
    Commentators argued that the definition of the grandfathered amount 
contained in Notice 2005-1, Q&A 16 with respect to nonaccount balance 
plans was not sufficiently flexible to account for subsequent increases 
in benefits unrelated to any further performance of services or 
increases in compensation after December 31, 2004. For example, a 
participant's benefit may increase if the participant becomes eligible 
for a subsidized benefit at a specified age that the participant 
reaches after December 31, 2004. In response, these proposed 
regulations provide that for nonaccount balance plans, the 
grandfathered amount specifically equals the present value as of 
December 31, 2004, of the amount to which the service provider would be 
entitled under the plan if the service provider voluntarily terminated 
services without cause on December 31, 2004, and received a payment of 
the benefits with the maximum value available from the plan on the 
earliest possible date allowed under the plan to receive a payment of 
benefits following the termination of services. Notwithstanding the 
foregoing, for any subsequent calendar year, the grandfathered amount 
may increase to equal the present value of the benefit the service 
provider actually becomes entitled to, determined under the terms of 
the plan (including applicable limits under the Code), as in effect on 
October 3, 2004, without regard to any further services rendered by the 
service provider after December 31, 2004, or any other events affecting 
the amount of, or the entitlement to, benefits (other than the 
participant's survival or a participant election under the terms of the 
plan with respect to the time or form of an available benefit).
    Because separation pay plans with respect to involuntary 
terminations and window programs are now treated as separate plans, 
these regulations provide a rule for calculating the grandfathered 
amount under such plans. For these purposes, the principles used to 
calculate the grandfathered amounts under a nonaccount balance plan and 
an account balance plan are to be applied by analogy, depending upon 
the structure of the separation pay plan.

C. Material Modifications

    Commentators have pointed out that a grandfathered plan may become 
subject to section 409A upon any material modification, even if such 
modification occurs many years after 2004. Given the substantial 
amounts of compensation that are deferred under grandfathered plans, as 
well as the potential for these amounts to grow through accumulated 
grandfathered earnings, the consequences of such a modification could 
be significant. Commentators expressed concern that as long as these 
plans exist, there will be the potential for a change to the plan to 
mistakenly cause the plan to become subject to section 409A. In 
response, these regulations include a provision stating that to the 
extent a modification is rescinded before the earlier of the date any 
additional right granted under the modification is exercised or the end 
of the calendar year in which the modification was made, the 
modification will not be treated as a material modification of the 
plan. For example, if a subsequent deferral feature is added that would 
allow participants to extend the time and form of payment of a 
grandfathered deferred amount, and if the right is removed before the 
earlier of the time the participant exercises the right or the end of 
the calendar year, then the modification will not be treated as a 
material modification of the plan. However, this provision is not 
intended to cover material modifications that are made with the 
knowledge that the modification will subject the amounts to section 
409A, but are then rescinded.
    Consistent with Notice 2005-1, Q&A-18(a), these regulations also 
provide that it is not a material modification to change a notional 
investment measure to, or to add, an investment measure that qualifies 
as a predetermined actual investment within the meaning of Sec.  
31.3121(v)(2)-1(d)(2) of this chapter. Commentators requested similar 
flexibility with respect to investment measures reflecting reasonable 
rates of interest. These regulations provide such flexibility, 
generally adopting a modified version of the rules contained in Sec.  
31.3121(v)(2)-1(d)(2) of this chapter. Under these regulations, it is 
not a material modification to change a notional investment measure to, 
or to add, an investment measure that qualifies as a predetermined 
actual investment within the meaning of Sec.  31.3121(v)(2)-1(d)(2) of 
this chapter or, for any given taxable year, reflects a reasonable rate 
of interest. For this purpose, if with respect to an amount deferred 
for a period, a plan provides for a fixed rate of interest to be 
credited, and the rate is to be reset under the plan at a specified 
future date that is not later than the end of the fifth calendar year 
that begins after the beginning of the period, the rate is reasonable 
at the beginning of the period, and the rate is not changed before the 
reset date, then the rate will be treated as reasonable in

[[Page 57954]]

all future periods before the reset date. These proposed regulations 
also contain other clarifications of the application of the material 
modification rule.

XI. Transition Relief

A. In General

    Until the effective date of these regulations, Notice 2005-1 
generally remains in effect. Notice 2005-1, Q&As-18 through 23. 
provided transition relief that was limited to the 2005 calendar year. 
Commentators generally reacted favorably to the scope of the transition 
rules. The Treasury Department and the IRS intended for the transition 
rules to be generous during the calendar year 2005, both to enable 
taxpayers to familiarize themselves with the new provisions, and also 
to provide a period during which the Treasury Department and the IRS 
could develop regulations and taxpayers generally could be confident 
that either their plans were not in violation of section 409A, or could 
be corrected to avoid additional tax under the statute.
    Because final regulations are not yet in place, the IRS and the 
Treasury Department are hereby extending through 2006 certain aspects 
of the transition relief provided for 2005 by Notice 2005-1. In 
addition, in response to questions, certain provisions of Notice 2005-1 
are clarified below. However, because taxpayers will have had, by the 
end of 2005, over a year to implement the statute, certain other 
transition relief is not being extended through 2006.

B. Amendment and Operation of Plans Adopted on or Before December 31, 
2006

    Pursuant to Notice 2005-1, Q&A-19, a plan adopted on or before 
December 31, 2005, will not be treated as violating section 409A(a)(2), 
(3) or (4) only if the plan is operated in good faith compliance with 
the provisions of section 409A and Notice 2005-1 during the calendar 
year 2005, and the plan is amended on or before December 31, 2005, to 
conform to the provisions of section 409A with respect to amounts 
subject to section 409A. To allow time to finalize these regulations, 
and for practitioners to implement the final regulations, the deadline 
by which plan documents must be amended to comply with the provisions 
of section 409A and the regulations is hereby extended to December 31, 
2006. Accordingly, in order to be treated as complying with section 
409A(a)(2), (3) or (4), a plan adopted before December 31, 2006, must 
be amended on or before December 31, 2006, either to conform to the 
provisions of section 409A with respect to amounts subject to section 
409A, or to provide a compensation arrangement that does not provide 
for a deferral of compensation for purposes of section 409A.
    The good faith compliance period provided under Q&A-19 of Notice 
2005-1 is also hereby extended through December 31, 2006. Accordingly, 
a plan adopted on or before December 31, 2006, will be treated as 
complying with section 409A(a)(2), (3) or (4) only if the plan is 
operated through December 31, 2006, in good faith compliance with the 
provisions of section 409A and Notice 2005-1. If any other guidance of 
general applicability under section 409A is published in the Internal 
Revenue Bulletin with an effective date prior to January 1, 2007, the 
plan must also comply with such published guidance as of its effective 
date. To the extent an issue is not addressed in Notice 2005-1 or such 
other published guidance, the plan must follow a good faith, reasonable 
interpretation of section 409A, and, to the extent not inconsistent 
therewith, the plan's terms.
    These regulations are not proposed to become effective prior to 
January 1, 2007, and, accordingly, a plan is not required to comply 
with either these proposed regulations or the final regulations prior 
to January 1, 2007. However, compliance with either these proposed 
regulations or the final regulations will be good faith compliance with 
the statute. In general, these proposed regulations expand upon, and 
should be read consistently with, the provisions of Notice 2005-1. 
However, to the extent that a provision of either these proposed 
regulations or the final regulations is inconsistent with a provision 
of Notice 2005-1, the plan may comply with the provision of the 
proposed or final regulations in lieu of the corresponding provision of 
Notice 2005-1.
    A plan will not be operating in good faith compliance if the plan 
sponsor exercises discretion under the terms of the plan, or a service 
provider exercises discretion with respect to that service provider's 
benefits, in a manner that causes the plan to fail to meet the 
requirements of section 409A. For example, if an employer retains the 
discretion under the terms of the plan to delay or extend payments 
under the plan and exercises such discretion, the plan will not be 
considered to be operated in good faith compliance with section 409A 
with regard to any plan participant. However, an exercise of a right 
under the terms of the plan by a service provider solely with respect 
to that service provider's benefits under the plan, in a manner that 
causes the plan to fail to meet the requirements of section 409A, will 
not be considered to result in the plan failing to be operated in good 
faith compliance with respect to other participants. For example, the 
request for and receipt of an immediate payment permitted under the 
terms of the plan if the participant forfeits 20 percent of the 
participant's benefits (a haircut) will be considered a failure of the 
plan to meet the requirements of section 409A with respect to that 
service provider, but not with respect to all other service providers 
under the plan.

C. Change in Payment Elections or Conditions on or Before December 31, 
2006

    Notice 2005-1, Q&A-19(c) provided generally that with respect to 
amounts subject to section 409A, a plan could be amended to provide for 
new payment elections without violating the subsequent deferral and 
anti-acceleration rules, provided that the plan was amended and the 
participant made the election on or before December 31, 2005. The 
period during which a plan may be amended and a service provider may be 
permitted to change payment elections, without resulting in an 
impermissible subsequent deferral or acceleration, is hereby extended 
through December 31, 2006, except that a service provider cannot in 
2006 change payment elections with respect to payments that the service 
provider would otherwise receive in 2006, or to cause payments to be 
made in 2006. Other provisions of the Internal Revenue Code and common 
law doctrines continue to apply to any such election.
    Accordingly, with respect to amounts subject to section 409A and 
amounts that would be treated as a short-term deferral within the 
meaning of Sec.  1.409A-1(b)(4), a plan may provide, or be amended to 
provide, for new payment elections on or before December 31, 2006, with 
respect to both the time and form of payment of such amounts and the 
election will not be treated as a change in the form and timing of a 
payment under section 409A(a)(4) or an acceleration of a payment under 
section 409A(a)(3), provided that the plan is so amended and the 
service provider makes any applicable election on or before December 
31, 2006, and provided that the amendment and election applies only to 
amounts that would not otherwise be payable in 2006 and does not cause 
an amount to be paid in 2006 that would not otherwise be payable in 
such year. Similarly, an outstanding stock right that provides for a 
deferral of

[[Page 57955]]

compensation subject to section 409A may be amended to provide for 
fixed payment terms consistent with section 409A, or to permit holders 
of such rights to elect fixed payment terms consistent with section 
409A, and such amendment or election will not be treated as a change in 
the time and form of a payment under section 409A(a)(4) or an 
acceleration of a payment under section 409A(a)(3), provided that the 
option or right is so amended and any elections are made, on or before 
December 31, 2006.

D. Payments Based Upon an Election Under a Qualified Plan for Periods 
Ending on or Before December 31, 2006

    For calendar year 2005, Notice 2005-1 Q&A-23 provides relief for 
nonqualified deferred compensation plans where the time and form of 
payment is controlled by the time and form of payment elected by the 
service provider under a qualified plan. Commentators indicated that 
this is a common arrangement with respect to nonqualified deferred 
compensation plans providing benefits calculated in relation to 
benefits accrued under a defined benefit qualified plan. Generally, the 
provisions with respect to the election of a time and form of a payment 
with respect to a qualified plan benefit would not comply with the 
requirements of section 409A were the plan subject to section 409A. 
Accordingly, election provisions under a nonqualified plan that 
mirrored or depended upon an election under a qualified plan generally 
would not comply with section 409A. The Treasury Department and the IRS 
were concerned that service providers, service recipients and plan 
administrators would not have sufficient time to solicit, retain and 
process new elections from service providers to comply with section 
409A in 2005. Accordingly, relief was provided in Notice 2005-1, Q&A-
23, under which an election under a nonqualified deferred compensation 
plan that was controlled by an election under a qualified plan could 
continue in effect during the calendar year 2005.
    Commentators requested that this relief be a permanent provision in 
the regulations. Although the Treasury Department and the IRS 
understand that such a provision would make the coordination of 
benefits under a qualified plan and benefits under a nonqualified 
deferred compensation plan calculated by reference to the qualified 
plan benefits easier to administer, the provisions of section 409A are 
not as flexible with respect to the timing of such elections as the 
qualified plan provisions. Given that the benefits under a nonqualified 
deferred compensation plan often dwarf the benefits provided under a 
qualified plan, the Treasury Department and the IRS do not believe that 
the importation of the more flexible qualified plan rules would be 
consistent with the legislative intent behind the enactment of section 
409A. Accordingly, the transition relief has not been made permanent. 
However, because other transition relief granting a participant the 
ability to change a time and form of payment through the end of the 
calendar year 2006 would, in many instances, allow a participant to 
elect the same time and form of payment that had been elected under the 
qualified plan, the relief is hereby extended through the calendar year 
2006.
    Accordingly, for periods ending on or before December 31, 2006, an 
election as to the timing and form of a payment under a nonqualified 
deferred compensation plan that is controlled by a payment election 
made by the service provider or beneficiary of the service provider 
under a qualified plan will not violate section 409A, provided that the 
determination of the timing and form of the payment is made in 
accordance with the terms of the nonqualified deferred compensation 
plan as of October 3, 2004, that govern payments. For this purpose, a 
qualified plan means a retirement plan qualified under section 401(a). 
For example, where a nonqualified deferred compensation plan provides 
as of October 3, 2004, that the time and form of payment to a service 
provider or beneficiary will be the same time and form of payment 
elected by the service provider or beneficiary under a related 
qualified plan, it will not be a violation of section 409A for the plan 
administrator to make or commence payments under the nonqualified 
deferred compensation plan on or after January 1, 2005, and on or 
before December 31, 2006, pursuant to the payment election under the 
related qualified plan. Notwithstanding the foregoing, other provisions 
of the Internal Revenue Code and common law tax doctrines continue to 
apply to any election as to the timing and form of a payment under a 
nonqualified deferred compensation plan.

E. Initial Deferral Elections

    Notice 2005-1, Q&A-21 provides relief with respect to initial 
deferral elections, generally permitting initial deferral elections 
with respect to deferrals relating all or in part to services performed 
on or before December 31, 2005, to be made on or before March 15, 2005. 
No extension is provided with respect to this relief with respect to 
initial elections to defer compensation. The Treasury Department and 
the IRS believe that sufficient guidance has been provided so that 
timely elections may be solicited and received from plan participants. 
In combination with the extension of flexibility with respect to 
amending the time and form of payments, the Treasury Department and the 
IRS believe that participants should be sufficiently informed to make a 
decision with respect to deferral elections.

F. Cancellation of Deferrals and Termination of Participation in a Plan

    Notice 2005-1, Q&A-20 provides a limited time during which a plan 
adopted before December 31, 2005, may provide a participant a right to 
terminate participation in the plan, or cancel an outstanding deferral 
election with regard to amounts subject to section 409A. Generally to 
qualify for this relief, if a plan amendment is necessary to permit the 
participant to terminate participation or cancel a deferral election, 
the plan amendment must be enacted and effective on or before December 
31, 2005, and whether or not the plan is amended, the amount subject to 
the termination or cancellation must be includible in income of the 
participant in the calendar year 2005 or, if later, in the taxable year 
in which the amounts are earned and vested.
    The period during which a service provider may cancel a deferral 
election or terminate participation in the plan is not extended. This 
relief was intended as a temporary period during which service 
providers could decide whether to continue to participate in an 
arrangement subject to section 409A. The Treasury Department and the 
IRS believe that the statute and existing guidance provide sufficient 
information for service providers to determine by December 31, 2005, 
whether to continue to participate in a particular arrangement, and 
that the further extension of this relief, and the relaxation of 
constructive receipt rules it entails, is not appropriate.
    A termination or cancellation pursuant to Notice 2005-1, Q&A-20 is 
treated as effective as of January 1, 2005, for purposes of section 
409A, and may apply in whole or in part to one or more plans in which a 
service provider participates and to one or more outstanding deferral 
elections the service provider has made with regard to amounts subject 
to section 409A. The exercise of a stock option, stock appreciation 
right or similar equity appreciation right that provides for a

[[Page 57956]]

deferral of compensation, on or before December 31, 2005, will be 
treated as a cancellation of a deferral.

G. Terminations of Grandfathered Plans

    Notice 2005-1, Q&A-18(c) provides that amending an arrangement on 
or before December 31, 2005, to terminate the arrangement and 
distribute the amounts of deferred compensation thereunder will not be 
treated as a material modification, provided that all amounts deferred 
under the plan are included in income in the taxable year in which the 
termination occurs. For the same reasons discussed above with respect 
to the period during which plans may allow participants to terminate 
participation in a plan, the relief provided in Notice 2005-1, Q&A-
18(c) is not extended.
    To qualify for the relief provided in Notice 2005-1, Q&A-18(c), the 
amendment to the plan must result in the termination of the arrangement 
and the distribution of all amounts deferred under the arrangement in 
the taxable year of such termination. An amendment to a plan to provide 
a participant a right to elect whether to terminate participation in 
the plan or to continue to defer amounts under the plan would not be 
covered by Q&A-18(c), and therefore would constitute a material 
modification of the plan. Accordingly, amounts that were not 
distributed pursuant to such an election and continued to be deferred 
under the plan would be subject to section 409A.

H. Substitutions of Non-discounted Stock Options and Stock Appreciation 
Rights for Discounted Stock Options and Stock Appreciation Rights

    Notice 2005-1, Q&A-18(d) provides that it will not be a material 
modification to replace a stock option or stock appreciation right 
otherwise providing for a deferral of compensation under section 409A 
with a stock option or stock appreciation right that would not have 
constituted a deferral of compensation under section 409A if it had 
been granted upon the original date of grant of the replaced stock 
option or stock appreciation right, provided that the cancellation and 
reissuance occurs on or before December 31, 2005. The period during 
which the cancellation and reissuance may occur is extended until 
December 31, 2006, but only to the extent such cancellation and 
reissuance does not result in the cancellation of a deferral in 
exchange for cash or vested property in 2006. For example, a discounted 
option generally may be replaced through December 31, 2006 with an 
option that would not have provided for a deferral of compensation, 
although the exercise of such a discounted option in 2006 before the 
cancellation and replacement generally would result in a violation of 
section 409A.
    Commentators pointed out that this relief could be interpreted as 
failing to cover discounted stock options or stock appreciation rights 
that were not earned and vested before January 1, 2005. Where 
replacement stock options or stock appreciation rights that would not 
constitute deferred compensation subject to section 409A are issued in 
accordance with the conditions set forth in Notice 2005-1, Q&A 18(d) 
and this preamble, such replacement stock options or stock appreciation 
rights will be treated for purposes of section 409A as if granted on 
the grant date of the original stock option or stock appreciation 
right. For example, provided that the conditions of Notice 2005-1, Q&A-
18(d) and this preamble are met, a discounted stock option granted in 
2003 that was not earned and vested before January 1, 2005, may be 
replaced with a stock option with an exercise price that would not have 
been discounted as of the original 2003 grant date, and the substituted 
stock option will be treated for purposes of section 409A as granted on 
the original 2003 grant date. Accordingly, if the substituted stock 
option would not have been subject to section 409A had it been granted 
on the original 2003 grant date, the substituted stock option will not 
be subject to section 409A.
    Commentators noted that some service recipients may wish to 
compensate the service provider for the lost discount. Commentators 
proposed three methods to provide such compensation. First, the service 
recipient may wish to pay the amount of the discount in 2005 in cash. 
As a cancellation of a deferral of compensation on or before December 
31, 2005 pursuant to Notice 2005-1, Q&A-20(a), this payment would not 
be subject to section 409A. Note that as a payment due to the 
cancellation of a deferral, such a payment could not be made in 2006 as 
this relief has not been extended beyond December 31, 2005. Where the 
stock option remains nonvested during the year of the option 
substitution, the service recipient may wish to make the compensation 
for the lost discount also subject to a vesting requirement. In that 
case, commentators also proposed granting restricted stock with a fair 
market value equal to the lost discount, subject to a vesting schedule 
parallel to the vesting schedule of the substituted option. As a 
transfer of property subject to section 83 that becomes substantially 
vested after the year of substitution, this grant would not be subject 
to section 409A. Finally, commentators proposed establishing a separate 
plan, promising a payment of the lost discount (plus earnings) subject 
to a vesting schedule parallel to the vesting schedule of the 
substituted option. Provided the right to the payment becomes 
substantially vested in a future year and otherwise meets the 
requirement of the short-term deferral exception in these regulations, 
the right to this payment would not constitute deferred compensation 
subject to section 409A. Alternatively, such an arrangement could 
itself provide for deferral of compensation beyond the year of 
substantial vesting and be subject to the requirements of section 409A, 
but if such requirements are met, would not affect the exclusion of the 
amended stock option or stock appreciation right from the treatment as 
a deferral of compensation subject to section 409A.

XII. Calculation and Timing of Income Inclusion Amounts

    To more rapidly issue guidance necessary to allow service 
recipients to comply with section 409A, the Treasury Department and the 
IRS have not included in these regulations guidance with respect to the 
calculation of the amounts of deferrals, or of the amounts of income 
inclusion upon the violation of the provisions of section 409A and 
these regulations, or the timing of the inclusion of income and related 
withholding obligations. The Treasury Department and the IRS anticipate 
that these topics will be addressed in subsequent guidance. The 
Treasury Department and the IRS request comments with respect to the 
calculation and timing of the income inclusion under section 409A, and 
specifically request comments in two areas.
    First, section 409A generally requires that for any taxable year in 
which an amount is deferred under a plan that fails to meet certain 
requirements, all amounts deferred must be included in income. This 
provision generally treats earnings (whether actual or notional) as 
amounts deferred subject to the inclusion provision. Service providers 
may experience negative earnings in a calendar year, such that the 
amounts to which a service provider has a right in a particular year 
are less than the amounts to which a service provider had a right in a 
previous year, even where no actual payments have been made. The 
Treasury Department and the IRS request comments with respect to 
whether and how such negative earnings may be accounted for in

[[Page 57957]]

determining the amount of deferrals and the amount of income inclusion 
for a given taxable year, particularly where continuing violations of 
section 409A extend to successive tax years.
    Second, the Treasury Department and the IRS understand that a 
method of calculation of current deferrals and of amounts to be 
included in income is needed for service recipients to meet their 
reporting and withholding obligations. Comments are requested as to 
what transitional relief may be appropriate depending upon when such 
future guidance is released. For interim guidance regarding the 
information reporting and wage withholding requirements applicable to 
deferrals of compensation within the meaning of section 409A, see 
Notice 2005-1, Q&A-24 through Q&A-38. Until further guidance is 
provided, taxpayers may rely on Notice 2005-1 regarding information 
reporting and wage withholding obligations.

XIII. Funding Arrangements

    Section 409A(b)(1) provides certain tax consequences for the 
funding of deferrals of compensation in offshore trusts (or other 
arrangements determined by the Secretary) or pursuant to a change in 
the financial health of the employer. The consequences of such funding 
are generally consistent with a violation of section 409A with respect 
to funded amounts. The Treasury Department and the IRS intend to 
address these provisions in future guidance. Commentators have 
requested guidance with respect to when assets will be treated as set 
aside, especially with respect to service recipients that are, or 
include, foreign corporations. Comments are requested as to what types 
of arrangements, other than actual trusts, should be treated similarly 
to trusts. In addition, these proposed regulations provide guidance 
with respect to the types of arrangements that constitute deferred 
compensation subject to section 409A. Because the funding rules of 
section 409A(b) apply only to amounts set aside to fund deferred 
compensation subject to section 409A, many issues raised by 
commentators with respect to foreign arrangements and funding may be 
addressed or limited through the definition of deferred compensation 
contained in these proposed regulations.

Proposed Effective Date

    These regulations are proposed to be generally applicable for 
taxable years beginning on or after January 1, 2007. As discussed, 
taxpayers may rely on these proposed regulations until the effective 
date of the final regulations.

Effect on Other Documents

    These proposed regulations do not affect the applicability of other 
guidance issued with respect to section 409A, including Notice 2005-1 
(2005-2 I.R.B. 274 (published as modified on January 6, 2005)). 
However, upon the effective date of the final regulations, the Treasury 
Department and the IRS anticipate that Notice 2005-1 and certain other 
published guidance will become obsolete for periods after the effective 
date of the final regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for January 25, 2006, beginning 
at 10 a.m. in the Auditorium of the Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments and an outline of the topics to be discussed and 
the time to be devoted to each topic (a signed original and eight (8) 
copies) by January 4, 2006. A period of 10 minutes will be allotted to 
each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

    The principal author of these regulations is Stephen Tackney of the 
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities). However, other personnel from the IRS and the 
Treasury Department participated in their development.

List of Subjects 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendment to the Regulations.

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Sections 1.409A-1 through 1.409A-6 are added to read as 
follows:


Sec.  1.409A-1  Definitions and covered arrangements.

    (a) Nonqualified deferred compensation plan--(1) In general. Except 
as otherwise provided in this paragraph (a), the term nonqualified 
deferred compensation plan means any plan (within the meaning of 
paragraph (c) of this section) that provides for the deferral of 
compensation (within the meaning of paragraph (b) of this section).
    (2) Qualified employer plans. The term nonqualified deferred 
compensation plan does not include--
    (i) Any plan described in section 401(a) that includes a trust 
exempt from tax under section 501(a);
    (ii) Any annuity plan described in section 403(a);
    (iii) Any annuity contract described in section 403(b);
    (iv) Any simplified employee pension (within the meaning of section 
408(k));
    (v) Any simple retirement account (within the meaning of section 
408(p);
    (vi) Any arrangement under which an active participant makes 
deductible contributions to a trust described in section 501(c)(18);

[[Page 57958]]

    (vii) Any eligible deferred compensation plan (within the meaning 
of section 457(b)); and
    (viii) Any plan described in section 415(m).
    (3) Certain foreign plans--(i) Participation addressed by treaty. 
With respect to an individual for a taxable year, the term nonqualified 
deferred compensation plan does not include any scheme, trust or 
arrangement maintained with respect to such individual, where 
contributions made by or on behalf of such individual to such scheme, 
trust or arrangement 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.
    (ii) Participation by nonresident aliens and certain resident 
aliens. With respect to an alien individual for a taxable year during 
which such individual is a nonresident alien or a resident alien 
classified as a resident alien solely under section 7701(b)(1)(A)(ii) 
(and not section 7701(b)(1)(A)(i)), the term nonqualified deferred 
compensation plan does not include any broad-based foreign retirement 
plan (within the meaning of paragraph (a)(3)(v) of this section) 
maintained by a person that is not a United States person.
    (iii) Participation by U.S. citizens and lawful permanent 
residents. With respect to an individual for a given taxable year 
during which such individual is a U.S. citizen or a resident alien 
classified as a resident alien under section 7701(b)(1)(A)(i), and is 
not eligible to participate in a qualified employer plan described in 
paragraph (a)(2) of this section, the term nonqualified deferred 
compensation plan does not include a broad-based foreign retirement 
plan (within the meaning of paragraph (a)(3)(v) of this section) 
maintained by a service recipient that is not a United States person, 
but only with respect to nonelective deferrals of foreign earned income 
(as defined in section 911(b)(1)) and only to the extent that the 
amounts deferred under such plan in such taxable year do not exceed the 
applicable limits under section 415(b) and (c) that would be applicable 
if such plan were a plan subject to section 415 and the foreign earned 
income of such individual were treated as compensation for purposes of 
applying section 415(b) and (c).
    (iv) Plans subject to a totalization agreement and similar plans. 
The term nonqualified deferred compensation plan does not include any 
social security system of a jurisdiction to the extent that benefits 
provided under or contributions made to the system are subject to an 
agreement entered into pursuant to section 233 of the Social Security 
Act with any foreign jurisdiction. In addition, the term nonqualified 
deferred compensation plan does not include a social security system of 
a foreign jurisdiction to the extent that benefits are provided under 
or contributions are made to a government-mandated plan as part of that 
foreign jurisdiction's social security system.
    (v) Broad-based retirement plan. For purposes of this paragraph 
(a)(3), the term broad-based retirement plan means a scheme, trust or 
arrangement that--
    (A) Is written;
    (B) In the case of an employer-maintained plan, is 
nondiscriminatory insofar as it (alone or in combination with other 
comparable plans) covers a wide range of employees, substantially all 
of whom are nonresident aliens or resident aliens classified as 
resident aliens solely under section 7701(b)(1)(A)(ii) (and not section 
7701(b)(1)(A)(i)), including rank and file employees, and actually 
provides significant benefits for the range of covered employees;
    (C) In the case of an employer-maintained plan, contains provisions 
that generally limit the employees' ability to use plan benefits for 
purposes other than retirement or restrict access to plan benefits 
prior to separation from service, such as restricting in-service 
distributions except in events similar to an unforeseeable emergency 
(as defined in Sec.  1.409A-3(g)(3)(i)) or hardship (as defined for 
purposes of section 401(k)(2)(B)(i)(IV)), and in all cases is subject 
to tax or plan provisions that discourage participants from using the 
assets for purposes other than retirement; and
    (D) Provides for payment of a reasonable level of benefits at 
death, a stated age, or an event related to work status, and otherwise 
requires minimum distributions under rules designed to ensure that any 
death benefits provided to the participants' survivors are merely 
incidental to the retirement benefits provided to the participants.
    (vi) Participation by a nonresident alien--de minimis amounts. With 
respect to a nonresident alien, the term nonqualified deferred 
compensation plan does not include any foreign plan maintained by a 
service recipient that is not a United States person for a taxable 
year, to the extent that the amounts deferred under the foreign plan 
based upon the nonresident alien's services performed in the United 
States (including compensation received due to services performed in 
the United States) do not exceed $10,000 in the taxable year.
    (4) Section 457 plans. A nonqualified deferred compensation plan 
under section 457(f) may constitute a nonqualified deferred 
compensation plan for purposes of this paragraph (a). The rules of 
section 409A apply to nonqualified deferred compensation plans 
separately and in addition to any requirements applicable to such plans 
under section 457(f). In addition, nonelective deferred compensation of 
nonemployees described in section 457(e)(12) and a grandfathered plan 
or arrangement described in Sec.  1.457-2(k)(4) may constitute a 
nonqualified deferred compensation plan for purposes of this paragraph 
(a). The term nonqualified deferred compensation plan does not include 
a length of service award to a bona fide volunteer under section 
457(e)(11)(A)(ii).
    (5) Certain welfare benefits. The term nonqualified deferred 
compensation plan does not include any bona fide vacation leave, sick 
leave, compensatory time, disability pay, or death benefit plan. For 
these purposes, the term disability pay has the same meaning as 
provided in Sec.  31.3121(v)(2)-1(b)(4)(iv)(C) of this chapter, and the 
term death benefit plan refers to a plan providing death benefits as 
defined in Sec.  31.3121(v)(2)-1(b)(4)(iv)(C) of this chapter. The term 
nonqualified deferred compensation plan also does not include any 
Archer Medical Savings Account as described in section 220, any Health 
Savings Account as described in section 223, or any other medical 
reimbursement arrangement, including a health reimbursement 
arrangement, that satisfies the requirements of section 105 and section 
106.
    (b) Deferral of compensation--(1) In general. Except as otherwise 
provided in paragraphs (b)(3) through (b)(9) of this section, a plan 
provides for the deferral of compensation if, under the terms of the 
plan and the relevant facts and circumstances, the service provider has 
a legally binding right during a taxable year to compensation that has 
not been actually or constructively received and included in gross 
income, and that, pursuant to the terms of the plan, is payable to (or 
on behalf of) the service provider in a later year. A service provider 
does not have a legally binding right to compensation if that 
compensation may be reduced unilaterally or eliminated by the service 
recipient or other person after the services creating the right to the 
compensation have been performed. However, if the facts and 
circumstances indicate that the discretion to reduce or

[[Page 57959]]

eliminate the compensation is available or exercisable only upon a 
condition, or the discretion to reduce or eliminate the compensation 
lacks substantive significance, a service provider will be considered 
to have a legally binding right to the compensation. Whether the 
negative discretion lacks substantive significance depends on the facts 
and circumstances of the particular arrangement. However, where the 
service provider to whom the compensation may be paid has effective 
control of the person retaining the discretion to reduce or eliminate 
the compensation, or has effective control over any portion of the 
compensation of the person retaining the discretion to reduce or 
eliminate the compensation, or is a member of the family (as defined in 
section 267(c)(4) applied as if the family of an individual includes 
the spouse of any member of the family) of the person retaining the 
discretion to reduce or eliminate the compensation, the discretion to 
reduce or eliminate the compensation will not be treated as having 
substantive significance. For this purpose, compensation is not 
considered subject to unilateral reduction or elimination merely 
because it may be reduced or eliminated by operation of the objective 
terms of the plan, such as the application of an objective provision 
creating a substantial risk of forfeiture. Similarly, a service 
provider does not fail to have a legally binding right to compensation 
merely because the amount of compensation is determined under a formula 
that provides for benefits to be offset by benefits provided under a 
plan that is qualified under section 401(a), or because benefits are 
reduced due to actual or notional investment losses, or in a final 
average pay plan, subsequent decreases in compensation.
    (2) Earnings. References to the deferral of compensation include 
references to earnings. When the right to earnings is specified under 
the terms of the arrangement, the legally binding right to earnings 
arises at the time of the deferral of the compensation to which the 
earnings relate. However, a plan may provide that the right to the 
earnings is treated separately from the right to the underlying 
compensation. For example, provided that the rules of section 409A are 
otherwise met, a plan may provide that earnings will be paid at a 
separate time or in a separate form from the payment of the underlying 
compensation. For the application of the deferral election rules to 
current payments of earnings and dividend equivalents, see Sec.  
1.409A-2(a)(13).
    (3) Compensation payable pursuant to the service recipient's 
customary payment timing arrangement. A deferral of compensation does 
not occur solely because compensation is paid after the last day of the 
service provider's taxable year pursuant to the timing arrangement 
under which the service recipient normally compensates service 
providers for services performed during a payroll period described in 
section 3401(b), or with respect to a non-employee service provider, a 
period not longer than the payroll period described in section 3401(b) 
or if no such payroll period exists, a period not longer than the 
earlier of the normal timing arrangement under which the service 
provider normally compensates non-employee service providers or 30 days 
after the end of the service provider's taxable year.
    (4) Short-term deferrals--(i) In general. A deferral of 
compensation does not occur if, absent an election by the service 
provider (including an election under Sec.  1.409A-2(a)(4)) to 
otherwise defer the payment of the compensation to a later period, an 
amount of compensation is actually or constructively received by the 
service provider by the later of the 15th day of the third month 
following the service provider's first taxable year in which the amount 
is no longer subject to a substantial risk of forfeiture or the 15th 
day of the third month following the end of the service recipient's 
first taxable year in which the amount is no longer subject to a 
substantial risk of forfeiture. In addition, the arrangement must not 
otherwise defer the payment to a later period. For example, an 
arrangement that deferred a payment until 5 years after the lapsing of 
a condition that constituted a substantial risk of forfeiture would 
constitute a deferral of compensation even if the amount were actually 
paid on the date the substantial risk of forfeiture lapsed. For these 
purposes, an amount that is never subject to a substantial risk of 
forfeiture is considered to be no longer subject to a substantial risk 
of forfeiture on the first date the service provider has a legally 
binding right to the amount. For example, an employer with a calendar 
year taxable year who on November 1, 2008, awards a bonus so that the 
employee is considered to have a legally binding right to the payment 
as of November 1, 2008, will not be considered to have provided for a 
deferral of compensation if, absent an election to otherwise defer the 
payment, the amount is paid or made available to the employee on or 
before March 15, 2009. An employer with a taxable year ending August 31 
who on November 1, 2008, awards a bonus so that the employee is 
considered to have a legally binding right to the payment as of 
November 1, 2008, will not be considered to have provided for a 
deferral of compensation if, absent an election to otherwise defer the 
payment, the amount is paid or made available to the employee on or 
before November 15, 2009.
    (ii) Delayed payments due to unforeseeable events. A payment that 
otherwise qualifies as a short-term deferral under paragraph (b)(4)(i) 
of this section but is made after the 15th day of the third month 
following the end of the relevant taxable year (the applicable 2\1/2\ 
month period) may continue to qualify as a short-term deferral if the 
taxpayer establishes that it was administratively impracticable to make 
the payment by the end of the applicable 2\1/2\ month period or that 
making the payment by the end of the applicable 2\1/2\ month period 
would have jeopardized the solvency of the service recipient, and, as 
of the date upon which the legally binding right to the compensation 
arose, such impracticability or insolvency was unforeseeable, and also 
the payment is made as soon as reasonably practicable. For example, an 
amount that would otherwise qualify as a short-term deferral except 
that the payment is made after the applicable 2\1/2\ month period may 
continue to qualify as a short-term deferral under this paragraph 
(b)(4) to the extent that the delay is caused either because the funds 
of the service recipient were not sufficient to make the payment before 
the end of the applicable 2\1/2\ month period without jeopardizing the 
solvency of the service recipient, or because it was not reasonably 
possible to determine by the end of the applicable 2\1/2\ month period 
whether payment of such amount was to be made, and the circumstance 
causing the delay was unforeseeable as of the date upon which the 
legally binding right to the compensation arose. Thus, the amount will 
not continue to qualify as a short-term deferral to the extent it was 
foreseeable, as of date upon which the legally binding right to the 
compensation arose, that the amount would not be paid within the 
applicable 2\1/2\ month period. For purposes of this paragraph 
(b)(4)(ii), an action or failure to act of the service provider or a 
person under the service provider's control, such as a failure to 
provide necessary information or documentation, is not an unforeseeable 
event.
    (5) Stock options, stock appreciation rights and other equity-based 
compensation--(i) Stock rights--(A) Nonstatutory stock options not 
providing for the deferral of

[[Page 57960]]

compensation. An option to purchase service recipient stock does not 
provide for a deferral of compensation if--
    (1) The amount required to purchase stock under the option (the 
exercise price) may never be less than the fair market value of the 
underlying stock (disregarding lapse restrictions as defined in Sec.  
1.83-3(i)) on the date the option is granted and the number of shares 
subject to the option is fixed on the original date of grant of the 
option;
    (2) The transfer or exercise of the option is subject to taxation 
under section 83 and Sec.  1.83-7; and
    (3) The option does not include any feature for the deferral of 
compensation other than the deferral of recognition of income until the 
later of exercise or disposition of the option under Sec.  1.83-7, or 
the time the stock acquired pursuant to the exercise of the option 
first becomes substantially vested (as defined in Sec.  1.83-3(b)).
    (B) Stock appreciation rights not providing for the deferral of 
compensation. A right to compensation equal to the appreciation in 
value of a specified number of shares of stock of the service recipient 
occurring between the date of grant and the date of exercise of such 
right (a stock appreciation right) does not provide for a deferral of 
compensation if--
    (1) Compensation payable under the stock appreciation right cannot 
be greater than the difference between the fair market value of the 
stock (disregarding lapse restrictions as defined in Sec.  1.83-3(i)) 
on the date of grant of the stock appreciation right and the fair 
market value of the stock (disregarding lapse restrictions as defined 
in Sec.  1.83-3(i)) on the date the stock appreciation right is 
exercised, with respect to a number of shares fixed on or before the 
date of grant of the right;
    (2) The stock appreciation right exercise price may never be less 
than the fair market value of the underlying stock (disregarding lapse 
restrictions as defined in Sec.  1.83-3(i)) on the date the right is 
granted; and
    (3) The stock appreciation right does not include any feature for 
the deferral of compensation other than the deferral of recognition of 
income until the exercise of the stock appreciation right.
    (C) Stock rights that may provide for the deferral of compensation. 
An option to purchase stock other than service recipient stock, or a 
stock appreciation right with respect to stock other than service 
recipient stock, generally will provide for the deferral of 
compensation within the meaning of this paragraph (b). If under the 
terms of an option to purchase service recipient stock (other than an 
incentive stock option described in section 422 or a stock option 
granted under an employee stock purchase plan described in section 
423), the amount required to purchase the stock is or could become less 
than the fair market value of the stock (disregarding lapse 
restrictions as defined in Sec.  1.83-3(i)) on the date of grant, the 
grant of the option may provide for the deferral of compensation within 
the meaning of this paragraph (b). If under the terms of a stock 
appreciation right with respect to service recipient stock, the 
compensation payable under the stock appreciation right is or could be 
any amount greater than, with respect to a predetermined number of 
shares, the difference between the stock value (disregarding lapse 
restrictions as defined in Sec.  1.83-3(i)) on the date of grant of the 
stock appreciation right and the stock value (disregarding lapse 
restrictions as defined in Sec.  1.83-3(i)) on the date the stock 
appreciation right is exercised, the grant of the stock appreciation 
right may provide for a deferral of compensation within the meaning of 
this paragraph (b).
    (D) Feature for the deferral of compensation. To the extent a stock 
right grants the recipient a right other than to receive cash or stock 
on the date of exercise and such additional rights allow for the 
deferral of compensation, the entire arrangement (including the 
underlying stock right) provides for the deferral of compensation. For 
purposes of this paragraph (b)(5)(i), neither the right to receive 
substantially nonvested stock (as defined in Sec.  1.83-3(b)) upon the 
exercise of a stock right, nor the right to pay the exercise price with 
previously acquired shares, constitutes a feature for the deferral of 
compensation.
    (E) Rights to dividends declared. For purposes of this paragraph 
(b)(5)(i), the right to receive, upon the exercise of a stock right, an 
amount equal to all or part of the dividends declared and paid on the 
number of shares underlying the stock right between the date of grant 
and the date of exercise of the stock right constitutes an offset to 
the exercise price of the stock option or an increase in the amount 
payable under the stock appreciation right (generally causing such 
stock rights to be subject to section 409A), unless the right to the 
dividends declared and paid on the number of shares underlying the 
stock right is explicitly set forth as a separate arrangement. If set 
forth as a separate arrangement, the arrangement may provide for 
deferred compensation for purposes of section 409A. However, the 
existence of a separate arrangement to receive such an amount that 
complies with the requirements of section 409A would not cause a stock 
right to fail to satisfy the requirements of the exclusion from the 
definition of deferred compensation provided in paragraphs (b)(5)(i)(A) 
and (B) of this section.
    (ii) Statutory stock options. The grant of an incentive stock 
option as described in section 422, or the grant of an option under an 
employee stock purchase plan described in section 423 (including the 
grant of an option with an exercise price discounted in accordance with 
section 423(b)(6) and the accompanying regulations), does not 
constitute a deferral of compensation. However, this paragraph 
(b)(5)(ii) does not apply to a modification, extension, or renewal of a 
statutory option that is treated as the grant of a new option that is 
not a statutory option. See Sec.  1.424-1(e). In such event, the option 
is treated as if it were a nonstatutory stock option at the date of the 
original grant, so that the modification, extension or renewal of the 
stock option that caused the stock option to be treated as the grant of 
a new option under Sec.  1.424-1(e) is treated as causing the option to 
be treated as the grant of a new option for purposes of this paragraph 
(b)(5) only if such modification, extension or renewal of the stock 
option would have been treated as resulting in the grant of a new 
option under paragraph (b)(5)(v) of this section.
    (iii) Stock of the service recipient--(A) In general. Except as 
otherwise provided in paragraphs (b)(5)(iii)(B) and (C) of this 
section, for purposes of this section, stock of the service recipient 
means stock that, as of the date of grant, is common stock of a 
corporation that is a service recipient (including any member of a 
group of corporations or other entities treated as a single service 
recipient) that is readily tradable on an established securities 
market, or if none, that class of common stock of such corporation 
having the greatest aggregate value of common stock issued and 
outstanding of such corporation, or common stock with substantially 
similar rights to stock of such class (disregarding any difference in 
voting rights). However, under no circumstances does stock of the 
service recipient include stock that is preferred as to liquidation or 
dividend rights or that includes or is subject to a mandatory 
repurchase obligation or a put or call right that is not a lapse 
restriction as defined in Sec.  1.83-3(i) and is based on a measure 
other than the fair market value (disregarding lapse restrictions as 
defined in Sec.  1.83-3(i)) of the equity interest in the corporation 
represented by the stock.
    (B) American depositary receipts. For purposes of this section, an 
American

[[Page 57961]]

depositary receipt or American depositary share may constitute service 
recipient stock, to the extent that the stock traded on a foreign 
securities market to which the American depositary receipt or American 
depositary share relates qualifies as service provider stock.
    (C) Mutual company units. For purposes of this section, mutual 
company units may constitute service recipient stock. For this purpose, 
the term mutual company unit means a fixed percentage of the overall 
value of a non-stock mutual company. For purposes of determining the 
value of the mutual company unit, the unit may be valued in accordance 
with the rules set forth in paragraph (b)(5)(iv)(B) of this section 
governing valuation of service recipient stock the shares of which are 
not traded on an established securities market, applied as if the 
mutual company were a stock corporation with one class of common stock 
and the number of shares of such stock determined according to the 
fixed percentage. For example, an appreciation right based on the 
appreciation of 10 mutual company units, where each unit is defined as 
1 percent of the overall value of the mutual company, would be valued 
as if the appreciation right were based upon 10 shares of a corporation 
with 100 shares of common stock and no other class of stock, whose 
shares are not readily tradable on an established securities market.
    (D) Definition of service recipient--(1) In general. For purposes 
of this paragraph (b)(5)(iii), the term service recipient generally has 
the same meaning as provided in paragraph (g) of this section, provided 
that a stock right, or the plan or arrangement under which the stock 
right is granted, may specify that in applying section 1563(a)(1), (2) 
and (3) for purposes of determining a controlled group of corporations 
under section 414(b), the language ``at least 50 percent'' is used 
instead of ``at least 80 percent'' each place it appears in section 
1563(a)(1), (2) and (3), and in applying Sec.  1.414(c)-2 for purposes 
of determining trades or businesses (whether or not incorporated) that 
are under common control for purposes of section 414(c), the language 
``at least 50 percent'' is used instead of ``at least 80 percent'' each 
place it appears in Sec.  1.414(c)-2. 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 term service 
recipient has the same meaning as provided in paragraph (g) of this 
section, provided that the stock right, or the plan or arrangement 
under which the stock right is granted, may specify that in applying 
sections 1563(a)(1), (2) and (3) for purposes of determining a 
controlled group of corporations under section 414(b), the language 
``at least 20 percent'' is used instead of ``at least 80 percent'' at 
each place it appears in sections 1563(a)(1), (2) and (3), and in 
applying Sec.  1.414(c)-2 for purposes of determining trades or 
businesses (whether or not incorporated) that are under common control 
for purposes of section 414(c), the language ``at least 20 percent'' is 
used instead of ``at least 80 percent'' at each place it appears in 
Sec.  1.414(c)-2. For example, stock of a corporation participating in 
a joint venture involving an operating business, used with respect to 
stock rights granted to employees of the joint venture who are former 
employees of such corporation, generally will constitute use of such 
stock based upon legitimate business criteria, and therefore could 
constitute service provider stock with respect to such employees if the 
corporation owns at least 20 percent of the joint venture and the other 
requirements of this paragraph (b)(5)(iii) are met. A designation by a 
service recipient to use the 50 percent or 20 percent thresholds 
described in this paragraph (b)(5)(iii)(D) must be applied consistently 
as to all compensatory stock rights for purposes of this paragraph 
(b)(5)(iii), and any designation of a different permissible ownership 
threshold percentage may not be made effective until 12 months after 
the adoption of such change.
    (2) Investment vehicles. Notwithstanding the provisions of 
paragraph (b)(5)(iii)(D)(1) of this section, except as to a service 
provider providing services directly to such corporation, for purposes 
of this paragraph (b)(5) the term service recipient does not include 
any corporation whose primary purpose is to serve as an investment 
vehicle with respect to the corporation's interest in entities other 
than the service recipient.
    (3) Substitutions and assumptions by reason of a corporate 
transaction. If the requirements of paragraph (b)(5)(v)(D) of this 
section are met such that the substitution of a new stock right 
pursuant to a corporate transaction for an outstanding stock right, or 
the assumption of an outstanding stock right pursuant to a corporate 
transaction, would not be treated as the grant of a new stock right or 
a change in the form of payment for purposes of section 409A, the stock 
underlying the stock right that is substituted or assumed will be 
treated as service recipient stock for purposes of applying this 
paragraph (b)(5) to the replacement stock rights. For example, where by 
reason of a spinoff transaction under which a subsidiary corporation is 
spun off from a distributing corporation, a distributing corporation 
employee's stock option to purchase distributing corporation stock is 
replaced with a stock option to purchase distributing corporation stock 
and a stock option to purchase the spun off subsidiary corporation's 
stock, and where such substitution is not treated as a modification of 
the original stock option pursuant to paragraph (b)(5)(v)(D) of this 
section, both the distributing corporation stock and the subsidiary 
corporation stock are treated as service recipient stock for purposes 
of applying this paragraph (b)(5) to the replacement stock options.
    (E) Stock rights granted on or before December 31, 2004. 
Notwithstanding the requirements of paragraph (b)(5)(iii)(A) of this 
section, any class of common stock of the service recipient with 
respect to which stock rights were granted to service providers on or 
before December 31, 2004, is treated as service recipient stock for 
purposes of this paragraph (b)(5)(iii), but only with respect to stock 
rights granted on or before December 31, 2004.
    (iv) Determination of the fair market value of service recipient 
stock--(A) Stock readily tradable on an established securities market. 
For purposes of (b)(5)(i) of this section, in the case of service 
recipient stock that is readily tradable on an established securities 
market, the fair market value of the stock may be determined based upon 
the last sale before or the first sale after the grant, the closing 
price on the trading day before or the trading day of the grant, or any 
other reasonable basis using actual transactions in such stock as 
reported by such market and consistently applied. The determination of 
fair market value also may be based upon an average selling price 
during a specified period that is within 30 days before or 30 days 
after the grant, provided that the commitment to grant the stock right 
based on such valuation method must be irrevocable before the beginning 
of the specified period, and such valuation method must be used 
consistently for grants of stock rights under the same and 
substantially similar programs.
    (B) Stock not readily tradable on an established securities 
market--(1) In general. For purposes of paragraph (b)(5)(i) of this 
section, in the case of service recipient stock that is not readily 
tradable on an established securities market, the fair market value of 
the stock as of a valuation date means a value determined by the 
reasonable application of a reasonable valuation

[[Page 57962]]

method. The determination of whether a valuation method is reasonable, 
or whether an application of a valuation method is reasonable, is made 
based on the facts and circumstances as of the valuation date. Factors 
to be considered under a reasonable valuation method include, as 
applicable, the value of tangible and intangible assets of the 
corporation, the present value of future cash-flows of the corporation, 
the market value of stock or equity interests in similar corporations 
and other entities engaged in trades or businesses substantially 
similar to those engaged in by the corporation whose stock is to be 
valued, the value of which can be readily determined through objective 
means (such as through trading prices on an established securities 
market or an amount paid in an arm's length private transaction), and 
other relevant factors such as control premiums or discounts for lack 
of marketability and whether the valuation method is used for other 
purposes that have a material economic effect on the service recipient, 
its stockholders or its creditors. The use of a valuation method is not 
reasonable if such valuation method does not take into consideration in 
applying its methodology, all available information material to the 
value of the corporation. Similarly, the use of a value previously 
calculated under a valuation method is not reasonable as of a later 
date if such calculation fails to reflect information available after 
the date of the calculation that may materially affect the value of the 
corporation (for example, the resolution of material litigation or the 
issuance of a patent) or the value was calculated with respect to a 
date that is more than 12 months earlier than the date for which the 
valuation is being used. The service recipient's consistent use of a 
valuation method to determine the value of its stock or assets for 
other purposes, including for purposes unrelated to compensation of 
service providers, is also a factor supporting the reasonableness of 
such valuation method.
    (2) Presumption of reasonableness. For purposes of this paragraph 
(b)(5)(iv)(B), the consistent use of any of the following methods of 
valuation is presumed to result in a reasonable valuation, provided 
that the Commissioner may rebut such a presumption upon a showing that 
either the valuation method or the application of such method was 
grossly unreasonable:
    (i) A valuation of a class of stock determined by an independent 
appraisal that meets the requirements of section 401(a)(28)(C) and the 
regulations thereunder as of a date that is no more than 12 months 
before the relevant transaction to which the valuation is applied (for 
example, the grant date of a stock option).
    (ii) A valuation based upon a formula that, if used as part of a 
nonlapse restriction (as defined in Sec.  1.83-3(h)) with respect to 
the stock, would be considered to be the fair market value of the stock 
pursuant to Sec.  1.83-5, provided that such stock is valued in the 
same manner for purposes of any nonlapse restriction applicable to the 
transfer of any shares of such class of stock (or substantially similar 
class of stock), and all noncompensatory purposes requiring the 
valuation of such stock, including regulatory filings, loan covenants, 
issuances to and repurchases of stock from persons other than service 
providers, and other third-party arrangements, and such valuation 
method is used consistently for all such purposes, and provided further 
that this paragraph (b)(5)(iv)(B)(2)(ii) does not apply with respect to 
stock subject to a stock right payable in stock, where the stock 
acquired pursuant to the exercise of the stock right is transferable 
other than through the operation of a nonlapse restriction.
    (iii) A valuation, made reasonably and in good faith and evidenced 
by a written report that takes into account the relevant factors 
described in paragraph (b)(5)(B)(iv)(1) of this section, of an illiquid 
stock of a start-up corporation. For this purpose, an illiquid stock of 
a start-up corporation is service recipient stock of a service 
recipient corporation that has no trade or business that it or any 
predecessor to it has conducted for a period of 10 years or more and 
has no class of equity securities that are traded on an established 
securities market (as defined in paragraph (k) of this section), where 
such stock is not subject to any put or call right or obligation of the 
service recipient or other person to purchase such stock (other than a 
right of first refusal upon an offer to purchase by a third party that 
is unrelated to the service recipient or service provider and other 
than a right or obligation that constitutes a lapse restriction as 
defined in Sec.  1.83-3(i)), and provided that this paragraph 
(b)(5)(iv)(B)(2)(iii) does not apply to the valuation of any stock if 
the service recipient or service provider may reasonably anticipate, as 
of the time the valuation is applied, that the service recipient will 
undergo a change in control event as described in Sec.  1.409A-
3(g)(5)(iv) or Sec.  1.409A-3(g)(5)(vi) or make a public offering of 
securities within the 12 months following the event to which the 
valuation is applied (for example, the grant of a stock option or 
exercise of a stock appreciation right). For purposes of this paragraph 
(b)(5)(iv)(B)(2)(iii), a valuation will not be treated as made 
reasonably and in good faith unless the valuation is performed by a 
person or persons with significant knowledge and experience or training 
in performing similar valuations.
    (3) Consistent use of a method. For purposes of paragraph 
(b)(5)(iv)(B)(2) of this section, the consistent use of a valuation 
method means the consistent use of the method for all equity-based 
compensation arrangements, including with respect to stock rights, for 
purposes of determining the exercise price, and with respect to stock 
appreciation rights not paid in stock, for purposes of determining the 
payment at the date of exercise, and for stock appreciation rights or 
stock options paid in stock subject to a put or call right providing 
for the potential repurchase by the service recipient, or other 
obligation of the service recipient or other person to purchase such 
stock, for purposes of determining the payment at the date of the 
purchase of such stock. Notwithstanding the foregoing, a service 
recipient may change the method prospectively for purposes of new 
grants of equity-based compensation, including stock rights. In 
addition, where after the date of grant, but before the date of 
exercise, of the stock right, the service provider stock to which the 
stock right relates becomes readily tradable on an established 
securities market, the service recipient must use the valuation method 
set forth in paragraph (b)(5)(iv)(A) of this section for purposes of 
determining the payment at the date of exercise or the purchase of the 
stock, as applicable.
    (v) Modifications, extensions, renewals, substitutions and 
assumptions of stock rights--(A) Treatment of modified stock right as a 
new grant. Any modification of the terms of a stock right, other than 
an extension or renewal of the stock right, is considered the granting 
of a new stock right. The new stock right may or may not constitute a 
deferral of compensation under paragraph (b)(5)(i) of this section, 
determined at the date of grant of the new stock right. Where a stock 
right is extended or renewed, the stock right is treated as having had 
an additional deferral feature from the date of grant.
    (B) Modification in general. The term modification means any change 
in the terms of the stock right (or change in the terms of the 
arrangement pursuant to which the stock right was granted or in the 
terms of any other agreement governing the stock right) that may 
provide the holder of the stock right with a direct or indirect 
reduction in the

[[Page 57963]]

exercise price of the stock right, or an additional deferral feature, 
or an extension or renewal of the stock right, regardless of whether 
the holder in fact benefits from the change in terms. In contrast, a 
change in the terms of the stock right shortening the period during 
which the stock right is exercisable is not a modification. It is not a 
modification to add a feature providing the ability to tender 
previously acquired stock for the stock purchasable under the stock 
right, or to withhold or have withheld shares of stock to facilitate 
the payment of employment taxes or required withholding taxes resulting 
from the exercise of the stock right. In addition, it is not a 
modification for the grantor to exercise discretion specifically 
reserved under a stock right with respect to the transferability of the 
stock right.
    (C) Extensions and renewals. An extension of a stock right refers 
to the granting to the holder of an additional period of time within 
which to exercise the stock right beyond the time originally 
prescribed, provided that it is not an extension if the exercise period 
of the stock right is extended to a date no later than the later of the 
15th day of the third month following the date at which, or December 31 
of the calendar year in which, the stock right would otherwise have 
expired if the stock right had not been extended, based on the terms of 
the stock right at the original grant date. For example, an option 
granted January 1, 2011, that expires upon the earlier of January 1, 
2021, or 30 days after separation from service will not be considered 
to be modified if, upon the holder's separation from service on July 1, 
2015, the term is extended to December 31, 2015. Notwithstanding the 
foregoing, it is not an extension of a stock right if the expiration of 
the stock right is tolled while the stock right is unexercisable 
because an exercise of the stock right would violate applicable 
securities laws, provided that the period during which the stock right 
may be exercised is not extended more than 30 days after the exercise 
of the stock right first would no longer violate applicable securities 
laws. A renewal of a stock right is the granting by the corporation of 
the same rights or privileges contained in the original stock right on 
the same terms and conditions.
    (D) Substitutions and assumptions of stock rights by reason of a 
corporate transaction. If the requirements of Sec.  1.424-1 would be 
met if the stock right were a statutory option, the substitution of a 
new stock right pursuant to a corporate transaction for an outstanding 
stock right or the assumption of an outstanding stock right pursuant to 
a corporate transaction will not be treated as the grant of a new stock 
right or a change in the form of payment for purposes of section 409A. 
For purposes of the preceding sentence, the requirement of Sec.  1.424-
1(a)(5)(iii) will be deemed to be satisfied if the ratio of the 
exercise price to the fair market value of the shares subject to the 
stock right immediately after the substitution or assumption is not 
greater than the ratio of the exercise price to the fair market value 
of the shares subject to the stock right immediately before the 
substitution or assumption. In the case of a transaction described in 
section 355 in which the stock of the distributing corporation and the 
stock distributed in the transaction are both readily tradable on an 
established securities market immediately after the transaction, for 
purposes of this paragraph (b)(5)(v), the requirements of Sec.  1.424-
1(a)(5) may be satisfied by using market quotations for the stock of 
the distributing corporation and the stock distributed in the 
transaction as of a predetermined date not more than 60 days after the 
transaction or based on an average of such market prices over a 
predetermined period of not more than 30 days ending not later than 60 
days after the transaction.
    (E) Acceleration of date when exercisable. If a stock right is not 
immediately exercisable in full, a change in the terms of the right to 
accelerate the time at which the stock right (or any portion thereof) 
may be exercised is not a material modification for purposes of this 
section. With respect to a stock right subject to section 409A, 
however, such an acceleration may constitute an impermissible 
acceleration of a payment date under Sec.  1.409A-3(c). Additionally, 
no modification occurs if a provision accelerating the time when a 
stock right may first be exercised is removed before the year in which 
it would otherwise be triggered.
    (F) Discretionary added benefits. If a change to a stock right 
provides, either by its terms or in substance, that the holder may 
receive an additional benefit under the stock right at the future 
discretion of the grantor, and the addition of such benefit would 
constitute a modification, then the addition of such discretion is a 
modification at the time that the stock right is changed to provide 
such discretion.
    (G) Change in underlying stock increasing value. A change in the 
terms of the stock subject to a stock right that increases the value of 
the stock is a modification of such stock right, except to the extent 
that a new stock right is substituted for such stock right by reason of 
the change in the terms of the stock in accordance with paragraph 
(b)(5)(v)(D) of this section.
    (H) Change in the number of shares purchasable. If a stock right is 
amended solely to increase the number of shares subject to the stock 
right, the increase is not considered a modification of the stock right 
but is treated as the grant of a new additional stock right to which 
the additional shares are subject. Notwithstanding the previous 
sentence, if the exercise price and number of shares subject to a stock 
right are proportionally adjusted to reflect a stock split (including a 
reverse stock split) or stock dividend, and the only effect of the 
stock split or stock dividend is to increase (or decrease) on a pro 
rata basis the number of shares owned by each shareholder of the class 
of stock subject to the stock right, then the stock right is not 
modified if it is proportionally adjusted to reflect the stock split or 
stock dividend and the aggregate exercise price of the stock right is 
not less than the aggregate exercise price before the stock split or 
stock dividend.
    (I) Rescission of changes. Any change to the terms of a stock right 
(or change in the terms of the plan pursuant to which the stock right 
was granted or in the terms of any other agreement governing the right) 
that would inadvertently result in treatment as a modification under 
paragraph (b)(5)(v)(A) of this section is not considered a modification 
of the stock right to the extent the change in the terms of the stock 
right is rescinded by the earlier of the date the stock right is 
exercised or the last day of the calendar year during which such change 
occurred. Thus, for example, if the terms of a stock right are changed 
on March 1 to extend the exercise period and the change is rescinded on 
November 1, then if the stock right is not exercised before the change 
is rescinded, the stock right is not considered modified under 
paragraph (b)(5)(v)(A) of this section.
    (J) Successive modifications. The rules of this paragraph (b)(5)(v) 
apply as well to successive modifications, including successive 
extensions or renewals.
    (6) Restricted Property--(i) In general. If a service provider 
receives property from, or pursuant to, a plan maintained by a service 
recipient, there is no deferral of compensation merely because the 
value of the property is not includible in income in the year of 
receipt by reason of the property being substantially nonvested (as 
defined in Sec.  1.83-3(b)), or is includible in income

[[Page 57964]]

solely due to a valid election under section 83(b). For purposes of 
this paragraph (b)(6)(i), a transfer of property includes the transfer 
of a beneficial interest in a trust or annuity plan, or a transfer to 
or from a trust or under an annuity plan, to the extent such a transfer 
is subject to section 83, section 402(b) or section 403(c).
    (ii) Promises to transfer property. A plan under which a service 
provider obtains a legally binding right to receive property (whether 
or not the property will be substantially nonvested (as defined in 
Sec.  1.83-3(b)) at the time of grant) in a future year may provide for 
the deferral of compensation and, accordingly, may constitute a 
nonqualified deferred compensation plan. The vesting of substantially 
nonvested property subject to section 83 may be treated as a payment 
for purposes section 409A, including for purposes of applying the 
short-term deferral rules under paragraph (b)(4) of this section. 
Accordingly, where the promise to transfer the substantially nonvested 
property and the right to retain the substantially nonvested property 
are both subject to a substantial risk of forfeiture (as defined under 
paragraph (d) of this section), the arrangement generally would 
constitute a short-term deferral under paragraph (b)(4) of this section 
because the payment would occur simultaneously with the vesting of the 
right to the property. For example, where an employee participates in a 
two-year bonus program such that, if the employee continues in 
employment for two years, the employee is entitled to either the 
immediate payment of a $10,000 cash bonus or the grant of restricted 
stock with a $15,000 fair market value subject to a vesting requirement 
of three additional years of service, the arrangement generally would 
constitute a short-term deferral under paragraph (b)(4) of this section 
because under either alternative the payment would be received within 
the short-term deferral period.
    (7) Arrangements between partnerships and partners. [Reserved.]
    (8) Certain foreign arrangements--(i) Arrangements with respect to 
compensation covered by treaty or other international agreement. An 
arrangement with a service provider does not provide for a deferral of 
compensation for purposes of this paragraph (b) to the extent that the 
compensation under the arrangement would have been excluded from gross 
income for Federal income tax purposes under the provisions of any 
bilateral income tax convention or other bilateral or multilateral 
agreement to which the United States is a party if the compensation had 
been paid to the service provider at the time that the legally binding 
right to the compensation first arose or, if later, the time that the 
legally binding right was no longer subject to a substantial risk of 
forfeiture.
    (ii) Arrangements with respect to certain other compensation. An 
arrangement with a service provider does not provide for a deferral of 
compensation for purposes of this paragraph (b) to the extent that 
compensation under the arrangement would not have been includible in 
gross income for Federal tax purposes if it had been paid to the 
service provider at the time that the legally binding right to the 
compensation first arose or, if later, the time that the legally 
binding right was no longer subject to a substantial risk of 
forfeiture, due to one of the following--
    (A) The service provider was a nonresident alien at such time and 
the compensation would not have been includible in gross income under 
section 872;
    (B) The service provider was a qualified individual (as defined in 
section 911(d)(1)) at such time and the compensation would have been 
foreign earned income within the meaning of section 911(b)(1) if paid 
at such time, the compensation would have been foreign earned income 
within the meaning of section 911(b)(1) that is less than the 
difference between the maximum exclusion amount under section 
911(b)(2)(D) for such taxable year and the amount of foreign earned 
income actually excludible from gross income by such qualified 
individual for such taxable year under section 911(a)(1);
    (C) The compensation would have been excludible from gross income 
under section 893; or
    (D) The compensation would have been excludible from gross income 
under section 931 or section 933.
    (iii) Tax equalization arrangements. Compensation paid under a tax 
equalization arrangement does not provide for a deferral of 
compensation, provided that any payment made under such arrangement is 
paid no later than the end of the second calendar year beginning after 
the calendar year in which the service provider's U.S. Federal income 
tax return is required to be filed (including extension) for the year 
to which the tax equalization payment relates. For purposes of this 
paragraph (b)(8)(iii), the term tax equalization arrangement refers to 
an arrangement that provides payments intended to compensate the 
service provider for the excess of the taxes actually imposed by a 
foreign jurisdiction on the compensation paid (other than the 
compensation under the tax equalization agreement) by the service 
recipient to the service provider over the taxes that would be imposed 
if the compensation were subject solely to United States Federal income 
tax, and provided that the payments made under such arrangement may not 
exceed such excess and the amount necessary to compensate for the 
additional taxes on the amounts paid under the arrangement.
    (iv) Additional foreign arrangements. An arrangement with a service 
provider does not provide for a deferral of compensation for purposes 
of this paragraph (b) to the extent designated by the Commissioner in 
revenue procedures, notices, or other guidance published in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter).
    (v) Earnings. Earnings on compensation excluded from the definition 
of deferral of compensation pursuant to this paragraph (b)(8) are also 
not treated as a deferred compensation. However, amounts that would be 
recharacterized as deferred compensation under Sec.  31.3121(v)(2)-
1(d)(2)(iii)(B) of this chapter (nonaccount balance plans), Sec.  
31.3121(v)(2)-1(d)(2)(iii)(A) of this chapter (account balance plans), 
or similar principles with respect to plans that are neither nonaccount 
balance plans nor account balance plans, will not be treated as 
earnings for purposes of this paragraph (b)(8)(v).
    (9) Separation pay arrangements--(i) In general. An arrangement 
that otherwise provides for a deferral of compensation under this 
paragraph (b) does not fail to provide a deferral of compensation 
merely because the right to payment of the compensation is conditioned 
upon a separation from service. However, see paragraphs (b)(9)(ii), 
(iii) and (iv) of this section for separation pay arrangements that do 
not provide for the deferral of compensation. Notwithstanding any other 
provision of this paragraph (b)(9), any payment or benefit, or 
entitlement to a payment or benefit, that acts as a substitute for, or 
replacement of, amounts deferred by the service recipient under a 
separate nonqualified deferred compensation plan constitutes a payment 
or a deferral of compensation under the separate nonqualified deferred 
compensation plan, and does not constitute a payment or deferral of 
compensation under a separation pay arrangement.
    (ii) Collectively bargained separation pay arrangements. A 
separation pay

[[Page 57965]]

arrangement does not provide for a deferral of compensation if the 
arrangement is a collectively bargained separation pay arrangement that 
provides for separation pay upon an actual involuntary separation from 
service or pursuant to a window program. Only the portion of the 
separation pay arrangement attributable to employees covered by a 
collective bargaining agreement is considered to be provided under a 
collectively bargained separation pay arrangement. A collectively 
bargained separation pay arrangement is a separation pay arrangement 
that meets the following conditions:
    (A) The separation pay arrangement is contained within an agreement 
that the Secretary of Labor determines to be a collective bargaining 
agreement.
    (B) The separation pay provided by the collective bargaining 
agreement was the subject of arms-length negotiations between employee 
representatives and one or more employers, and the agreement between 
employee representatives and one or more employers satisfies section 
7701(a)(46).
    (C) The circumstances surrounding the agreement evidence good faith 
bargaining between adverse parties over the separation pay to be 
provided under the agreement.
    (iii) Separation pay plans due to involuntary separation from 
service or participation in a window program. A separation pay plan 
that is not described in paragraph (b)(9)(ii) of this section and that 
provides for separation pay upon an actual involuntary separation from 
service or pursuant to a window program does not provide for a deferral 
of compensation if the plan provides that--
    (A) The separation pay (other than amounts described in paragraph 
(b)(9)(iv) of this section) may not exceed two times the lesser of--
    (1) The sum of the service provider's annual compensation (as 
defined in Sec.  1.415-1(d)(2)) for services provided to the service 
recipient as an employee and the service provider's net earnings from 
self-employment (as defined in section 1402(a)(1)) for services 
provided to the service recipient as an independent contractor, each 
for the calendar year preceding the calendar year in which the service 
provider has a separation from service from such service recipient; or
    (2) The maximum amount that may be taken into account under a 
qualified plan pursuant to section 401(a)(17) for such year; and
    (B) The separation pay must be paid no later than December 31 of 
the second calendar year following the calendar year in which occurs 
the separation from service.
    (iv) Reimbursements and certain other separation payments--(A) In 
general. To the extent a separation pay arrangement entitles a service 
provider to payment by the service recipient for a limited period of 
time of reimbursements that are otherwise excludible from gross income, 
of reimbursements for expenses that the service provider can deduct 
under section 162 or section 167 as business expenses incurred in 
connection with the performance of services (ignoring any applicable 
limitation based on adjusted gross income), or of reasonable 
outplacement expenses and reasonable moving expenses actually incurred 
by the service provider and directly related to the termination of 
services for the service recipient, such arrangement does not provide 
for a deferral of compensation. To the extent a separation pay 
arrangement (including an arrangement involving payments due to a 
voluntary separation from service) entitles a service provider to 
reimbursement by the service recipient for a limited period of time of 
payments of medical expenses incurred and paid by the service provider 
but not reimbursed and allowable as a deduction under section 213 
(disregarding the requirement of section 213(a) that the deduction is 
available only to the extent that such expenses exceed 7.5 percent of 
adjusted gross income), such arrangement does not provide for a 
deferral of compensation.
    (B) In-kind benefits and direct service recipient payments. A 
service provider's entitlement to in-kind benefits from the service 
recipient, or a payment by the service recipient directly to the person 
providing the goods or services to the service provider, will also be 
treated as not providing for a deferral of compensation for purposes of 
this paragraph (b), if a right to reimbursement by the service 
recipient for a payment for such benefits, goods or services by the 
service provider would not be treated as providing for a deferral of 
compensation under this paragraph (b)(9)(iv).
    (C) De minimis payments. In addition, if not otherwise excluded, to 
the extent a separation pay arrangement entitles a service provider to 
reimbursements or other payments or benefits that do not exceed $5,000 
in the aggregate, such arrangement does not provide for a deferral of 
compensation.
    (D) Limited period of time. For purposes of paragraphs 
(b)(9)(iv)(A) and (B), a limited period of time refers to both the 
period during which applicable expenses may be incurred, and the period 
during which reimbursements must be paid, and may not extend beyond the 
December 31 of the second calendar year following the calendar year in 
which the separation from service occurred.
    (v) Window programs--definition. The term window program refers to 
a program established by the service recipient to provide for 
separation pay in connection with a separation from service, for a 
limited period of time (no greater than one year), to service providers 
who separate from service during that period or to service providers 
who separate from service during that period under specified 
circumstances. A program will not be considered a window program if a 
service recipient establishes a pattern of repeatedly providing for 
similar separation pay in similar situations for substantially 
consecutive, limited periods of time. Whether the recurrence of these 
programs constitutes a pattern is determined based on the facts and 
circumstances. Although no one factor is determinative, relevant 
factors include whether the benefits are on account of a specific 
business event or condition, the degree to which the separation pay 
relates to the event or condition, and whether the event or condition 
is temporary or discrete or is a permanent aspect of the employer's 
business.
    (c) Plan--(1) In general. The term plan includes any agreement, 
method or arrangement, including an agreement, method or arrangement 
that applies to one person or individual. A plan may be adopted 
unilaterally by the service recipient or may be negotiated or agreed to 
by the service recipient and one or more service providers or service 
provider representatives. An agreement, method or arrangement may 
constitute a plan regardless of whether it is an employee benefit plan 
under section 3(3) of the Employee Retirement Income Security Act of 
1974 (ERISA), as amended (29 U.S.C. 1002(3)). The requirements of 
section 409A are applied as if a separate plan or plans is maintained 
for each service provider.
    (2) Plan aggregation rules--(i) In general. Except as provided in 
paragraph (c)(2)(ii) of this section, with respect to arrangements 
between a service provider and a service recipient--
    (A) All amounts deferred with respect to that service provider 
under all account balance plans of the service recipient (as defined in 
Sec.  31.3121(v)(2)-1(c)(1)(ii)(A) of this chapter) other than a 
separation pay arrangement described in paragraph (c)(2)(i)(C) of this 
section

[[Page 57966]]

are treated as deferred under a single plan;
    (B) All amounts deferred with respect to that service provider 
under all nonaccount balance plans of the service recipient (as defined 
in Sec.  31.3121(v)(2)-1(c)(2)(i) of this chapter) other than a 
separation pay arrangement described in paragraph (c)(2)(i)(C) of this 
section are treated as deferred under a separate single plan;
    (C) All amounts deferred with respect to that service provider 
under all separation pay arrangements (as defined in paragraph (m) of 
this section) of the service recipient due to an involuntary 
termination or participation in a window program are treated as 
deferred under a single plan; and
    (D) All amounts deferred with respect to that service provider 
under all plans of the service recipient that are not described in 
paragraph (c)(2)(i)(A), (B) or (C) of this section (for example, 
discounted stock options, stock appreciation rights or other equity-
based compensation described in Sec.  31.3121(v)(2)-1(b)(4)(ii) of this 
chapter) are treated as deferred under a separate single plan.
    (ii) Dual status. Arrangements in which a service provider 
participates are not aggregated to the extent the service provider 
participates in one set of arrangements due to status as an employee of 
the service recipient (employee arrangements) and another set of 
arrangements due to status as an independent contractor of the service 
recipient (independent contractor arrangements). For example, where a 
service provider deferred amounts under an arrangement while providing 
services as an independent contractor, and then becomes eligible for 
and defers amounts under a separate arrangement after being hired as an 
employee, the two arrangements will not be aggregated for purposes of 
this paragraph (c)(2). Where an employee also serves as a director of 
the service recipient (or a similar position with respect to a non-
corporate service recipient), the arrangements under which the employee 
participates as a director of the service recipient (director 
arrangements) are not aggregated with employee arrangements, provided 
that the director arrangements are substantially similar to 
arrangements provided to service providers providing services only as 
directors (or similar positions with respect to non-corporate service 
recipients). For example, an employee director who participates in an 
employee arrangement and a director arrangement generally may treat the 
two arrangements as separate plans, provided that the director 
arrangement is substantially similar to an arrangement providing 
benefits to a non-employee director. Director arrangements and 
independent contractor arrangements are aggregated for purposes of this 
paragraph (c)(2).
    (3) Establishment of arrangement--(i) In general. To satisfy the 
requirements of section 409A, an arrangement must be established and 
maintained by a service recipient, in both form and operation, in 
accordance with the requirements of section 409A and these regulations. 
For purposes of this paragraph (c)(3), an arrangement is established on 
the latest of the date on which it is adopted, the date on which it is 
effective, and the date on which the material terms of the plan are set 
forth in writing. For purposes of this paragraph (c)(3)(i), an 
arrangement will be deemed to be set forth in writing if it is set 
forth in any other form that is approved by the Commissioner. The 
material terms of the arrangement include the amount (or the method or 
formula for determining the amount) of deferred compensation to be 
provided under the arrangement and the time when it will be paid. 
Notwithstanding the foregoing, an arrangement will be deemed to be 
established as of the date the participant obtains a legally binding 
right to deferred compensation, provided that the arrangement is 
otherwise established under the rules of this paragraph (c)(3)(i) by 
the end of the calendar year in which the legally binding right arises, 
or with respect to an amount not payable in the year immediately 
following the year in which the legally binding right arises (the 
subsequent year), the 15th day of the third month of the subsequent 
year.
    (ii) Amendments to the arrangement. In the case of an amendment 
that increases the amount deferred under an arrangement providing for 
the deferral of compensation, the arrangement is not considered 
established with respect to the additional amount deferred until the 
arrangement, as amended, is established in accordance with paragraph 
(c)(3)(i) of this section.
    (iii) Transition rule for written plan requirement. For purposes of 
this section, an unwritten arrangement that was adopted and effective 
before December 31, 2006, is treated as established under this section 
as of the later of the date on which it was adopted or became 
effective, provided that the material terms of the arrangement are set 
forth in writing on or before December 31, 2006.
    (iv) Plan aggregation rules. The plan aggregation rules of 
paragraph (c)(2)(i) of this section do not apply to the requirements of 
paragraphs (c)(3)(i) and (ii) of this section. Accordingly, an 
arrangement that fails to meet the requirements of section 409A solely 
due to a failure to meet the requirements of paragraph (c)(3)(i) or 
(ii) is not aggregated with other arrangements that meet such 
requirements.
    (d) Substantial risk of forfeiture--(1) In general. Compensation is 
subject to a substantial risk of forfeiture if entitlement to the 
amount is conditioned on the performance of substantial future services 
by any person or the occurrence of a condition related to a purpose of 
the compensation, and the possibility of forfeiture is substantial. For 
purposes of this paragraph (d), a condition related to a purpose of the 
compensation must relate to the service provider's performance for the 
service recipient or the service recipient's business activities or 
organizational goals (for example, the attainment of a prescribed level 
of earnings, equity value or an initial public offering). Any addition 
of a substantial risk of forfeiture after the legally binding right to 
the compensation arises, or any extension of a period during which 
compensation is subject to a substantial risk of forfeiture, in either 
case whether elected by the service provider, service recipient or 
other person (or by agreement of two or more of such persons), is 
disregarded for purposes of determining whether such compensation is 
subject to a substantial risk of forfeiture. An amount is not subject 
to a substantial risk of forfeiture merely because the right to the 
amount is conditioned, directly or indirectly, upon the refraining from 
performance of services. For purposes of section 409A, an amount will 
not be considered subject to a substantial risk of forfeiture beyond 
the date or time at which the recipient otherwise could have elected to 
receive the amount of compensation, unless the amount subject to a 
substantial risk of forfeiture (ignoring earnings) is materially 
greater than the amount the recipient otherwise could have elected to 
receive. For example, a salary deferral generally may not be made 
subject to a substantial risk of forfeiture. But, for example, where a 
bonus arrangement provides an election between a cash payment of a 
certain amount or restricted stock units with a materially greater 
value that will be forfeited absent continued services for a period of 
years, the right to the restricted stock units generally will be 
treated as subject to a substantial risk of forfeiture.
    (2) Stock rights. A stock right will be treated as not subject to a 
substantial risk of forfeiture at the earlier of the first date the 
holder may exercise the stock

[[Page 57967]]

right and receive cash or property that is substantially vested (as 
defined in Sec.  1.83-3(b)) or the first date that the stock right is 
not subject to a forfeiture condition that would constitute a 
substantial risk of forfeiture. Accordingly, a stock option that the 
service provider may exercise immediately and receive substantially 
vested stock will be treated as not subject to a substantial risk of 
forfeiture, even if the stock option automatically terminates upon the 
service provider's separation from service.
    (3) Enforcement of forfeiture condition--(i) In general. In 
determining whether the possibility of forfeiture is substantial in the 
case of rights to compensation granted by a service recipient to a 
service provider that owns a significant amount of the total combined 
voting power or value of all classes of equity of the service recipient 
or of its parent, all relevant facts and circumstances will be taken 
into account in determining whether the probability of the service 
recipient enforcing such condition is substantial, including--
    (A) The service provider's relationship to other equity holders and 
the extent of their control, potential control and possible loss of 
control of the service recipient;
    (B) The position of the service provider in the service recipient 
and the extent to which the service provider is subordinate to other 
service providers;
    (C) The service provider's relationship to the officers and 
directors of the service recipient (or similar positions with respect 
to a noncorporate service recipient);
    (D) The person or persons who must approve the service provider's 
discharge; and
    (E) Past actions of the service recipient in enforcing the 
restrictions.
    (ii) Examples. The following examples illustrate the rules of 
paragraph (d)(3)(i) of this section:

    Example 1.  A service provider would be considered as having 
deferred compensation subject to a substantial risk of forfeiture, 
but for the fact that the service provider owns 20 percent of the 
single class of stock in the transferor corporation. If the 
remaining 80 percent of the class of stock is owned by an unrelated 
individual (or members of such an individual's family) so that the 
possibility of the corporation enforcing a restriction on such 
rights is substantial, then such rights are subject to a substantial 
risk of forfeiture.
    Example 2.  A service provider would be considered as having 
deferred compensation subject to a substantial risk of forfeiture, 
but for the fact that the service provider who is president of the 
corporation, also owns 4 percent of the voting power of all the 
stock of a corporation. If the remaining stock is so diversely held 
by the public that the president, in effect, controls the 
corporation, then the possibility of the corporation enforcing a 
restriction on the right to deferred compensation of the president 
is not substantial, and such rights are not subject to a substantial 
risk of forfeiture.

    (e) Performance-based compensation--(1) In general. The term 
performance-based compensation means compensation where the amount of, 
or entitlement to, the compensation is contingent on the satisfaction 
of preestablished organizational or individual performance criteria 
relating to a performance period of at least 12 consecutive months in 
which the service provider performs services. Organizational or 
individual performance criteria are considered preestablished if 
established in writing by not later than 90 days after the commencement 
of the period of service to which the criteria relates, provided that 
the outcome is substantially uncertain at the time the criteria are 
established. Performance-based compensation may include payments based 
on performance criteria that are not approved by a compensation 
committee of the board of directors (or similar entity in the case of a 
non-corporate service recipient) or by the stockholders or members of 
the service recipient. Notwithstanding the foregoing, performance-based 
compensation does not include any amount or portion of any amount that 
will be paid either regardless of performance, or based upon a level of 
performance that is substantially certain to be met at the time the 
criteria is established. Except as provided in paragraph (e)(3) of this 
section, compensation is not performance-based compensation merely 
because the amount of such compensation is based on the value of, or 
increase in the value of, the service recipient or the stock of the 
service recipient.
    (2) Payments based upon subjective performance criteria. The term 
performance-based compensation may include payments based upon 
subjective performance criteria, provided that--
    (i) The subjective performance criteria relate to the performance 
of the participant service provider, a group of service providers that 
includes the participant service provider, or a business unit for which 
the participant service provider provides services (which may include 
the entire organization); and
    (ii) The determination that any subjective performance criteria 
have been met is not made by the participant service provider or a 
family member of the participant service provider (as defined in 
section 267(c)(4) applied as if the family of an individual includes 
the spouse of any member of the family), or a person under the 
supervision of the participant service provider or such a family 
member, or where any amount of the compensation of the person making 
such determination is controlled in whole or in part by the service 
provider or such a family member.
    (3) Equity-based compensation. Compensation is performance-based 
compensation if it is based solely on an increase in the value of the 
service recipient, or stock of the service recipient, after the date of 
a grant or award. If the amount of compensation the service provider 
will receive under a grant or award is not based solely on an increase 
in the value of the service recipient, or stock of the service 
recipient, after the date of the grant or award (for example, a stock 
appreciation right granted with an exercise price that is less than the 
fair market value of the stock as of the date of grant), and that other 
amount would not otherwise qualify as performance-based compensation, 
the compensation attributable to the grant or award does not qualify as 
performance-based compensation. Notwithstanding the foregoing, an award 
of equity-based compensation may constitute performance-based 
compensation if entitlement to the compensation is subject to a 
condition that would cause the award to otherwise qualify as 
performance-based compensation, such as a performance-based vesting 
condition. The eligibility to defer compensation under an equity-based 
compensation award constitutes an additional deferral feature with 
respect to the award for purposes of the definition of a deferral of 
compensation under paragraph (b)(5) of this section.
    (f) Service provider--(1) In general. The term service provider 
includes--
    (i) An individual, corporation, subchapter S corporation or 
partnership;
    (ii) A personal service corporation (as defined in section 
269A(b)(1)), or a noncorporate entity that would be a personal service 
corporation if it were a corporation; or
    (iii) A qualified personal service corporation (as defined in 
section 448(d)(2)), or a noncorporate entity that would be a qualified 
personal service corporation if it were a corporation.
    (2) Service providers using an accrual method of accounting. 
Section 409A does not apply to a deferral under an arrangement between 
taxpayers if, for the taxable year in which the service provider 
taxpayer obtains a legally binding right to the compensation, the

[[Page 57968]]

service provider uses an accrual method of accounting for Federal tax 
purposes.
    (3) Independent contractors--(i) In general. Except as otherwise 
provided in paragraph (f)(3)(iv) of this section, section 409A does not 
apply to an amount deferred under an arrangement between a service 
provider and service recipient with respect to a particular trade or 
business in which the service provider participates, if during the 
service provider's taxable year in which the service provider obtains a 
legally binding right to the payment of the amount deferred--
    (A) 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;
    (B) The service provider 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 (as defined in paragraph 
(f)(3)(ii) of this section); and
    (C) The service provider is not related to the service recipient, 
applying the definition of related person contained in paragraph 
(f)(3)(ii) of this section subject to the modification that the 
language ``50 percent'' is used instead of ``20 percent'' each place it 
appears in sections 267(b)(1) and 707(b)(1).
    (ii) Related person. For purposes of this paragraph (f)(3), a 
person is related to another person if the persons bear a relationship 
to each other that is specified in section 267(b) or 707(b)(1), subject 
to the modifications that the language ``20 percent'' is used instead 
of ``50 percent'' each place it appears in sections 267(b) and 
707(b)(1), and section 267(c)(4) is applied as if the family of an 
individual includes the spouse of any member of the family; or the 
persons are engaged in trades or businesses under common control 
(within the meaning of section 52(a) and (b)). In addition, an 
individual is related to an entity if the individual is an officer of 
an entity that is a corporation, or holds a position substantially 
similar to an officer of a corporation with an entity that is not a 
corporation.
    (iii) Significant services. Whether a service provider is providing 
significant services depends on the facts and circumstances of each 
case. However, for purposes of paragraph (f)(3)(i) of this section, a 
service provider who provides services to two or more service 
recipients to which the service provider is not related and that are 
not related to one another is deemed to be providing significant 
services to two or more of such service recipients for a given taxable 
year, 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 revenue generated by 
the service provider from the trade or business of providing such 
services.
    (iv) Management services. A service provider is treated as related 
to a service recipient for purposes of paragraph (f)(3)(i) of this 
section if the service provider provides management services to the 
service recipient. For purposes of this paragraph (f)(3)(iv), the term 
management services means services that involve the actual or de facto 
direction or control of the financial or operational aspects of a trade 
or business of the service recipient, or investment advisory services 
provided to a service recipient whose primary trade or business 
includes the management of financial assets (including investments in 
real estate) for its own account, such as a hedge fund or a real estate 
investment trust.
    (g) Service recipient. Except as otherwise specifically provided in 
these regulations, the term service recipient means the person for whom 
the services are performed and with respect to whom the legally binding 
right to compensation arises, and all persons with whom such person 
would be considered a single employer under section 414(b) (employees 
of controlled group of corporations), and all persons with whom such 
person would be considered a single employer under section 414(c) 
(employees of partnerships, proprietorships, etc., under common 
control). For example, where the service provider is an employee, the 
service recipient generally is the employer. Notwithstanding the 
foregoing, section 409A applies to a plan that provides for the 
deferral of compensation, even though the payment of the compensation 
is not made by the person for whom services are performed.
    (h) Separation from service--(1) Employees--(i) In general. An 
employee separates from service with the service recipient if the 
employee dies, retires, or otherwise has a termination of employment 
with the employer. However, for purposes of this paragraph (h)(1), the 
employment relationship is treated as continuing intact while the 
individual is on military leave, sick leave, or other bona fide leave 
of absence (such as temporary employment by the government) if the 
period of such leave does not exceed six months, or if longer, so long 
as the individual's right to reemployment with the service recipient is 
provided either by statute or by contract. If the period of leave 
exceeds six months and the individual's right to reemployment is not 
provided either by statute or by contract, the employment relationship 
is deemed to terminate on the first date immediately following such 
six-month period.
    (ii) Termination of employment. Whether a termination of employment 
has occurred is determined based on the facts and circumstances. Where 
an employee either actually or purportedly continues in the capacity as 
an employee, such as through the execution of an employment agreement 
under which the employee agrees to be available to perform services if 
requested, but the facts and circumstances indicate that the employer 
and the employee did not intend for the employee to provide more than 
insignificant services for the employer, an employee will be treated as 
having a separation from service for purposes of this paragraph (h)(1). 
For purposes of the preceding sentence, an employer and employee will 
not be treated as having intended for the employee to provide 
insignificant services where the employee continues to provide services 
as an employee at an annual rate that is at least equal to 20 percent 
of the services rendered, on average, during the immediately preceding 
three full calendar years of employment (or, if employed less than 
three years, such lesser period) and the annual remuneration for such 
services is at least equal to 20 percent of the average annual 
remuneration earned during the final three full calendar years of 
employment (or, if less, such lesser period). Where an employee 
continues to provide services to a previous employer in a capacity 
other than as an employee, a separation from service will not be deemed 
to have occurred for purposes of this paragraph (h)(1) if the former 
employee is providing services at an annual rate that is 50 percent or 
more of the services rendered, on average, during the immediately 
preceding three full calendar years of employment (or if employed less 
than three years, such lesser period) and the annual remuneration for 
such services is 50 percent or more of the annual remuneration earned 
during the final three full calendar years of employment (or if less, 
such lesser period). For purposes of this paragraph (h)(1)(ii), the 
annual rate of providing services is determined based upon the 
measurement used to determine the service provider's base compensation 
(for example, amounts of time required to earn salary, hourly wages, or 
payments for specific projects).
    (2) Independent contractors--(i) In general. An independent 
contractor is considered to have a separation from

[[Page 57969]]

service with the service recipient upon the expiration of the contract 
(or in the case of more than one contract, all contracts) under which 
services are performed for the service recipient if the expiration 
constitutes a good-faith and complete termination of the contractual 
relationship. An expiration does not constitute a good faith and 
complete termination of the contractual relationship if the service 
recipient anticipates a renewal of a contractual relationship or the 
independent contractor becoming an employee. For this purpose, a 
service recipient is considered to anticipate the renewal of the 
contractual relationship with an independent contractor if it intends 
to contract again for the services provided under the expired contract, 
and neither the service recipient nor the independent contractor has 
eliminated the independent contractor as a possible provider of 
services under any such new contract. Further, a service recipient is 
considered to intend to contract again for the services provided under 
an expired contract if the service recipient's doing so is conditioned 
only upon incurring a need for the services, the availability of funds, 
or both.
    (ii) Special rule. Notwithstanding paragraph (b)(2) of this 
section, the plan is considered to satisfy the requirement described in 
paragraph (a) of this section that no amounts deferred under the plan 
be paid or made available to the participant before the participant has 
a separation from service with the service recipient if, with respect 
to amounts payable to a participant who is an independent contractor, a 
plan provides that--
    (A) No amount will be paid to the participant before a date at 
least 12 months after the day on which the contract expires under which 
services are performed for the service recipient (or, in the case of 
more than one contract, all such contracts expire); and
    (B) No amount payable to the participant on that date will be paid 
to the participant if, after the expiration of the contract (or 
contracts) and before that date, the participant performs services for 
the service recipient as an independent contractor or an employee.
    (i) Specified employee--(1) In general. The term specified employee 
means a key employee (as defined in section 416(i) without regard to 
section 416(i)(5)) of a service recipient any stock of which is 
publicly traded on an established securities market or otherwise. For 
purposes of this paragraph (i)(1), an employee is a key employee if the 
employee meets the requirements of section 416(i)(1)(A)(i), (ii) or 
(iii) (applied in accordance with the regulations thereunder and 
disregarding section 416(i)(5)) at any time during the 12-month period 
ending on an identification date. If a person is a key employee as of 
an identification date, the person is treated as a specified employee 
for the 12-month period beginning on the first day of the fourth month 
following the identification date. A service recipient may designate 
any date in a calendar year as the identification date provided that a 
service recipient must use the same identification date with respect to 
all arrangements, and any change to the identification date may not be 
effective for a period of 12 months. If no identification date is 
designated, the identification date is December 31. The service 
recipient may designate an identification date through inclusion in 
each plan document or through a separate document, provided that the 
service recipient will not be treated as having designated an 
identification date on any date before the execution of the document 
containing the designation. Notwithstanding the foregoing, any 
designation of an identification date made on or before December 31, 
2006, may be applied to any separation from service occurring on or 
after January 1, 2005. Whether any stock of a service recipient is 
publicly traded on an established securities market or otherwise must 
be determined as of the date of the employee's separation from service.
    (2) Spinoffs and mergers. Where a new corporation or entity (new 
corporation) is established as part of a corporate division governed by 
section 355 from a corporation that is publicly traded on an 
established securities market or otherwise (old corporation), any 
employee of the new corporation who was a key employee of the old 
corporation immediately prior to the spinoff is a key employee of the 
new corporation until the end of the 12-month period beginning on the 
first day of the fourth month following the old corporation's last 
identification date preceding the spinoff transaction. Where two 
corporations (pre-merger corporations) are merged or become part of the 
same controlled group of corporations so as to be treated as a single 
service recipient under paragraph (g) of this section, any employee of 
the merged corporation who was a key employee of either of the pre-
merger corporations immediately before the merger is a key employee of 
the merged corporation until the first day of the fourth month after 
the identification date of the merged corporation next following the 
merger.
    (3) Nonresident alien employees. For purposes of determining key 
employees, a service recipient generally must include all employees, 
including employees who are nonresident aliens. However, a plan may 
provide without causing an amount to be treated as an additional 
deferral as to any affected participant that for purposes of applying 
the six-month delay to specified employees, all employees that are 
nonresident aliens during the entire 12-month period ending with the 
relevant identification date are excluded for purposes of determining 
which employees meet the requirements of section 416(i)(1)(A)(i), (ii) 
or (iii) (applied in accordance with the regulations thereunder and 
disregarding section 416(i)(5)); provided that a service recipient must 
apply such exclusion with respect to all arrangements of the service 
recipient, and any change to include such nonresident alien employees 
may not be effective for a period of 12 months.
    (j) Nonresident alien--(1) Except as provided in paragraph (j)(2) 
of this section, for purposes of this section the term nonresident 
alien means an individual who is--
    (i) A nonresident alien within the meaning of section 
7701(b)(1)(B); or
    (ii) A dual resident taxpayer within the meaning of Sec.  
301.7701(b)-7(a)(1) of this chapter with respect to any taxable year in 
which such individual is treated as a nonresident alien for purposes of 
computing the individual's U.S. income tax liability.
    (2) The term nonresident alien does not include--
    (i) A nonresident alien with respect to whom an election is in 
effect for the taxable year under section 6013(g) to be treated as a 
resident of the United States;
    (ii) A former citizen or long-term resident (within the meaning of 
section 877(e)(2)) who expatriated after June 3, 2004, and has not 
complied with the requirements of section 7701(n); or
    (iii) An individual who is treated as a citizen or resident of the 
United States for the taxable year under section 877(g).
    (k) Established securities market. For purposes of section 409A and 
the regulations thereunder, the term established securities market 
means an established securities market within the meaning of Sec.  
1.897-1(m).
    (l) Stock right. For purposes of section 409A and these 
regulations, the term stock right means a stock option (other than an 
incentive stock option described in section 422 or an option granted 
pursuant to an employee stock purchase

[[Page 57970]]

plan described in section 423) or a stock appreciation right.
    (m) Separation pay arrangement. For purposes of section 409A and 
the regulations thereunder, the term separation pay arrangement means 
any arrangement that provides separation pay or, where an arrangement 
provides both amounts that are separation pay and that are not 
separation pay, that portion of the arrangement that provides 
separation pay. For purposes of this paragraph (m), the term separation 
pay means any amount of compensation where one of the conditions to the 
right to the payment is a separation from service, whether voluntary or 
involuntary, including payments in the form of reimbursements of 
expenses incurred, and the provision of other taxable benefits. 
Separation pay includes amounts payable due to a separation from 
service, regardless of whether payment is conditioned upon the 
execution of a release of claims, noncompetition or nondisclosure 
provisions, or other similar requirement. Notwithstanding the 
foregoing, any amount, or entitlement to any amount, that acts as a 
substitute for, or replacement of, amounts deferred by the service 
recipient under a separate nonqualified deferred compensation plan 
constitutes a payment of compensation or deferral of compensation under 
the separate nonqualified deferred compensation plan, and does not 
constitute separation pay.


Sec.  1.409A-2  Deferral elections.

    (a) Initial elections as to the time and form of payment--(1) In 
general. An arrangement that is, or constitutes part of, a nonqualified 
deferred compensation plan meets the requirements of section 
409A(a)(4)(B) only if the arrangement provides that compensation for 
services performed during a service provider's taxable year (the 
service year) may be deferred at the service provider's election only 
if the election to defer such compensation is made and becomes 
irrevocable not later than the end of such period as may be permitted 
in this paragraph (a). An election will not be considered to be 
revocable merely because the service provider may make an election to 
change the time and form of payment pursuant to paragraph (b) of this 
section. Whether an arrangement provides a service provider an 
opportunity to elect the time or form of payment of compensation is 
determined based upon all the facts and circumstances surrounding the 
determination of the time and form of payment of the compensation. For 
purposes of this section, an election to defer includes an election as 
to the time of the payment, an election as to the form of the payment 
or an election as to both the time and the form of the payment, but 
does not include an election as to the medium of payment (for example, 
an election between a payment of cash or a payment of property). Except 
as otherwise provided in these regulations, an election will not be 
considered made until such election becomes irrevocable under the terms 
of the relevant arrangement. Thus, a plan may provide that an election 
to defer may be changed at any time prior to the last permissible date 
for making such an election. Where an arrangement provides the service 
provider a right to make an initial deferral election, and further 
provides that the election remains in effect until terminated or 
modified by the service provider, the election will be treated as made 
as of the date such election becomes irrevocable as to compensation for 
services performed during the relevant service year. For example, where 
an arrangement provides that a service provider's election to defer a 
set percentage will remain in effect until changed or revoked, but that 
as of each December 31 the election becomes irrevocable with respect to 
salary payable with respect to services performed in the immediately 
following year, the initial deferral election with respect to salary 
payable with respect to services performed in the immediately following 
year will be deemed to have been made as of the December 31 upon which 
the election became irrevocable.
    (2) General rule. An arrangement that is, or constitutes part of, a 
nonqualified deferred compensation plan meets the requirements of 
section 409A(a)(4)(B) if the plan provides that compensation for 
services performed during a service provider's taxable year (the 
service year) may be deferred at the service provider's election only 
if the election to defer such compensation is made not later than the 
close of the service provider's taxable year next preceding the service 
year.
    (3) Initial deferral election with respect to short-term deferrals. 
With respect to a legally binding right to a payment of compensation in 
a subsequent taxable year that, absent a deferral election, would not 
be treated as a deferral of compensation pursuant to Sec.  1.409A-
1(b)(4), an election to defer such compensation may be made in 
accordance with the requirements of paragraph (b) of this section, 
applied as if the amount were a deferral of compensation and the 
scheduled payment date for the amount were the date the substantial 
risk of forfeiture lapses. Notwithstanding the requirements of 
paragraph (b) of this section, such a deferral election may provide 
that the deferred amounts will be payable upon a change in control 
event (as defined in Sec.  1.409A-3(g)(5)) without regard to the 5-year 
additional deferral requirement.
    (4) Initial deferral election with respect to certain forfeitable 
rights. With respect to a legally binding right to a payment in a 
subsequent year that is subject to a forfeiture condition requiring the 
service provider's continued services for a period of at least 12 
months from the date the service provider obtains the legally binding 
right, an election to defer such compensation may be made on or before 
the 30th day after the service provider obtains the legally binding 
right to the compensation, provided that the election is made at least 
12 months in advance of the earliest date at which the forfeiture 
condition could lapse.
    (5) Initial deferral election with respect to a service recipient 
with a fiscal year other than the calendar year. In the case of a 
service recipient with a fiscal year other than the calendar year, a 
plan may provide that fiscal year compensation may be deferred at the 
service provider's election only if the election to defer such 
compensation is made not later than the close of the service 
recipient's fiscal year next preceding the first fiscal year in which 
are performed any services for which such compensation is payable. For 
purposes of this paragraph (a)(5), the term fiscal year compensation 
means compensation relating to a period of service coextensive with one 
or more consecutive fiscal years of the service recipient, of which no 
amount is paid or payable during the service period. For example, 
fiscal year compensation generally would include a bonus based on a 
service period of the two consecutive fiscal years ending September 30, 
2009, where the amount will be paid after the completion of the service 
period, but would not include either a bonus based on a calendar year 
service period or salary that would otherwise be paid during the 
service recipient's fiscal year.
    (6) First year of eligibility. In the case of the first year in 
which a service provider becomes eligible to participate in a plan (as 
defined in Sec.  1.409A-1(c)), the service provider may make an initial 
deferral election within 30 days after the date the service provider 
becomes eligible to participate in such plan, with respect to 
compensation paid for services to be performed subsequent to the 
election. In the case of a plan that does not provide for service 
provider

[[Page 57971]]

elections with respect to the time or form of a payment, the time and 
form of the payment must be specified on or before the date that is 30 
days after the date the service provider becomes eligible to 
participate in such plan. For compensation that is earned based upon a 
specified performance period (for example, an annual bonus), where a 
deferral election is made in the first year of eligibility but after 
the beginning of the service period, the election will be deemed to 
apply to compensation paid for services performed subsequent to the 
election if the election applies to the portion of the compensation 
equal to the total amount of the compensation for the service period 
multiplied by the ratio of the number of days remaining in the 
performance period after the election over the total number of days in 
the performance period.
    (7) Performance-based compensation. In the case of any performance-
based compensation based upon a performance period of at least 12 
months, provided that the service provider performed services 
continuously from a date no later than the date upon which the 
performance criteria are established through a date no earlier than the 
date upon which the service provider makes an initial deferral 
election, an initial deferral election may be made with respect to such 
performance-based compensation no later than the date that is six 
months before the end of the performance period, provided that in no 
event may an election to defer performance-based compensation be made 
after such compensation has become both substantially certain to be 
paid and readily ascertainable.
    (8) Nonqualified deferred compensation arrangements linked to 
qualified plans. With respect to an amount deferred under an 
arrangement that is, or constitutes part of, a nonqualified deferred 
compensation plan, where under the terms of the nonqualified deferred 
compensation arrangement the amount deferred under the plan is the 
amount determined under the formula under which benefits are determined 
under a qualified employer plan (as defined in Sec.  1.409A-1(a)(2)) 
applied without respect to one or more limitations applicable to 
qualified employer plans under the Internal Revenue Code or other 
applicable law, or is determined as an amount offset by some or all of 
the benefits provided under the qualified employer plan, the operation 
of the qualified employer plan with respect to changes in benefit 
limitations applicable to qualified employer plans under the Internal 
Revenue Code or other applicable law does not constitute a deferral 
election even if such operation results in an increase of amounts 
deferred under the nonqualified deferred compensation arrangement, 
provided that such operation does not otherwise result in a change in 
the time or form of a payment under the nonqualified deferred 
compensation plan. In addition, with respect to such a nonqualified 
deferred compensation arrangement, the following actions or failures to 
act will not constitute a deferral election under the nonqualified 
deferred compensation arrangement even if in accordance with the terms 
of the nonqualified deferred compensation arrangement, the actions or 
inactions result in an increase in the amounts deferred under the 
arrangement, provided that such actions or inactions do not otherwise 
affect the time or form of payment under the nonqualified deferred 
compensation plan:
    (i) A service provider's action or inaction under the qualified 
plan with respect to whether to elect to receive a subsidized benefit 
or an ancillary benefit under the qualified plan.
    (ii) The amendment of a qualified plan to add or remove a 
subsidized benefit or an ancillary benefit, or to freeze or limit 
future accruals of benefits under the qualified plan.
    (iii) A service provider's action or inaction under a qualified 
plan subject to section 402(g), including an adjustment to a deferral 
election under the qualified plan subject to section 402(g), provided 
that for any given calendar year, the service provider's action or 
inaction does not result in an increase in the amounts deferred under 
all nonqualified deferred compensation arrangements in which the 
service provider participates in excess of the limit with respect to 
elective deferrals under section 402(g) in effect for the taxable year 
in which such action or inaction occurs.
    (iv) A service provider's action or inaction under a qualified plan 
with respect to elective deferrals or after-tax contributions by the 
service provider to the qualified plan that affects the amounts that 
are credited under a nonqualified deferred compensation arrangement as 
matching amounts or other amounts contingent on service provider 
elective deferrals or after-tax contributions, provided that such 
matching or contingent amounts, as applicable, are either forfeited or 
never credited under the nonqualified deferred compensation arrangement 
in the absence of such service provider's elective deferral or after-
tax contribution, and provided further that all of the service 
provider's actions or inactions do not result in an increase during 
such taxable year in the amounts deferred under all nonqualified 
deferred compensation arrangements in which the service provider 
participates in excess of the limit with respect to elective deferrals 
under section 402(g) in effect for the taxable year in which such 
action or inaction occurs. See paragraph (b)(6) of this section, 
Example 12 and Example 13.
    (9) Separation pay. In the case of separation pay (as defined in 
Sec.  1.409A-1(b)(9)(i)) due to an actual involuntary separation from 
service, where such separation pay is the subject of bona fide, arm's 
length negotiations, the initial deferral election may be made at any 
time up to the time the service provider obtains a legally binding 
right to the payment. In the case of separation pay due to 
participation in a window program (as defined in Sec.  1.409A-
1(b)(9)(v)), the initial deferral election may be made at any time up 
to the time the election to participate in the window program becomes 
irrevocable.
    (10) Commissions. For purposes of this paragraph (a), in the case 
of commission compensation, a service provider earning such 
compensation is treated as providing the services to which such 
compensation relates only in the year in which the customer remits 
payment to the service recipient. For purposes of this paragraph 
(a)(10), the term commission compensation means compensation or 
portions of compensation earned by a service provider if a substantial 
portion of the services provided by such service provider to a service 
recipient consist of the direct sale of a product or service to a 
customer, the compensation paid by the service recipient to the service 
provider consists of either a portion of the purchase price for the 
product or service or an amount calculated solely by reference to the 
volume of sales, and payment of the compensation is contingent upon the 
service recipient receiving payment from an unrelated customer for the 
product or services. For this purpose, a customer is treated as an 
unrelated customer only if the customer is not related to either the 
service provider or the service recipient. A person is treated as 
related to another person if the person would be treated as related to 
the other person under Sec.  1.409A-1(f)(3)(ii) or the person would be 
treated as providing management services to the other person under 
Sec.  1.409A-1(f)(3)(iv).
    (11) Initial deferral elections with respect to compensation paid 
for final payroll period--(i) In general. Unless an arrangement 
provides otherwise, compensation payable after the last day

[[Page 57972]]

of the service provider's taxable year solely for services performed 
during the final payroll period described in section 3401(b) containing 
the last day of the service provider's taxable year or, with respect to 
a non-employee service provider, a period not longer than the payroll 
period described in section 3401(b), where such amount is payable 
pursuant to the timing arrangement under which the service recipient 
normally compensates service providers for services performed during a 
payroll period described in section 3401(b), or with respect to a non-
employee service provider, a period not longer than the payroll period 
described in section 3401(b), is treated as compensation for services 
performed in the subsequent taxable year. The preceding sentence does 
not apply to any compensation paid during such period for services 
performed during any period other than such final payroll period, such 
as a payment of an annual bonus. Any amendment of an arrangement after 
December 31, 2006, to add a provision providing for a differing 
treatment of such compensation may not be effective for 12 months from 
the date the amendment is executed and enacted.
    (ii) Transition rule. For purposes of this paragraph (a)(11), an 
arrangement that was adopted and effective before December 31, 2006, 
whether written or unwritten, will be treated as designating such 
compensation for service performed in the taxable year in which the 
payroll period ends, unless otherwise set forth in writing before 
December 31, 2006.
    (12) Designation of time and form of payment with respect to a 
nonelective arrangement. An arrangement that provides for a deferral of 
compensation for services performed during a service provider's taxable 
year that does not provide the service provider with an opportunity to 
elect the time of payment of such compensation must specify the time of 
payment no later than the time the service provider first has a legally 
binding right to the compensation. Similarly, an arrangement that 
provides for a deferral of compensation for services performed during a 
service provider's taxable year that does not provide the service 
provider with an opportunity to elect the form of payment of such 
compensation must specify the form of payment no later than the time 
the service provider first has a legally binding right to the 
compensation. Such designation shall be treated as an initial deferral 
election for purposes of this section.
    (13) Designation of time and form of payment with respect to 
earnings. An arrangement that provides for actual or notional earnings 
to be credited on amounts of deferred compensation may specify, in 
accordance with the requirements of this paragraph (a), that such 
earnings will be paid by a date not later than the 15th day of the 
third month following the calendar year for which the earnings are 
credited. To satisfy the requirements of this paragraph (a)(13), actual 
or notional earnings must be credited at least annually and the measure 
for such earnings must be either a specified, nondiscretionary interest 
rate (or a specified, nondiscretionary formula describing an interest 
rate such as, for example, the interest on a Treasury bond + 2 percent) 
or a predetermined actual investment within the meaning of Sec.  
31.3121(v)(2)-1(d)(2) of this chapter. For these purposes, a right to 
dividend equivalents with respect to a specified number of shares of 
service recipient stock (as defined in Sec.  1.409A-1(b)(5)(iii)) may 
be treated as a right to actual or notional earnings on an amount of 
deferred compensation.
    (b) Subsequent changes in time and form of payment--(1) In general. 
The requirements of section 409A(a)(4)(C) are met if, in the case of a 
plan that permits a subsequent election to delay a payment or to change 
the form of payment of an amount of deferred compensation, the 
following conditions are met:
    (i) The plan requires that such election may not take effect until 
at least 12 months after the date on which the election is made.
    (ii) In the case of an election related to a payment not described 
in Sec.  1.409A-3(a)(2) (payment on account of disability), Sec.  
1.409A-3(a)(3) (payment on account of death) or Sec.  1.409A-3(a)(6) 
(payment on account of the occurrence of an unforeseeable emergency), 
the plan requires that the payment with respect to which such election 
is made be deferred for a period of not less than 5 years from the date 
such payment would otherwise have been paid (or in the case of a life 
annuity or installment payments treated as a single payment, 5 years 
from the date the first amount was scheduled to be paid).
    (iii) The plan requires that any election related to a payment 
described in Sec.  1.409A-3(a)(4) (payment at a specified time or 
pursuant to a fixed schedule) may not be made less than 12 months prior 
to the date the payment is scheduled to be paid (or in the case of a 
life annuity or installment payments treated as a single payment, 12 
months prior to the date the first amount was scheduled to be paid).
    (2) Definition of payments for purposes of subsequent changes in 
the time or form of payment--(i) In general. Except as provided in 
paragraphs (b)(2)(ii) and (iii) of this section, the term payment 
refers to each separately identified amount to which a service provider 
is entitled to payment under a plan on a determinable date, and 
includes amounts applied for the benefit of the service provider. An 
amount is separately identified only if the amount may be objectively 
determined. For example, an amount identified as 10 percent of the 
account balance as of a specified payment date would be a separately 
identified amount. A payment includes the provision of any taxable 
benefit, including payment in cash or in kind. In addition, a payment 
includes, but is not limited to, the transfer, cancellation or 
reduction of an amount of deferred compensation in exchange for 
benefits under a welfare benefit plan, fringe benefit excludible under 
section 119 or section 132, or any other benefit that is excluded from 
gross income.
    (ii) Life annuities. The entitlement to a life annuity is treated 
as the entitlement to a single payment. For purposes of this paragraph 
(b)(2)(ii), the term life annuity means a series of substantially equal 
periodic payments, payable not less frequently than annually, for the 
life (or life expectancy) of the service provider or the joint lives 
(or life expectancies) of the service provider and the service 
provider's designated beneficiary. A change in the form of a payment 
from one type of life annuity to another type of life annuity before 
any annuity payment has been made is not considered a change in the 
time and form of a payment, provided that the annuities are actuarially 
equivalent applying reasonable actuarial assumptions.
    (iii) Installment payments. The entitlement to a series of 
installment payments that is not a life annuity is treated as the 
entitlement to a single payment, unless the arrangement provides at all 
times with respect to the amount deferred that the right to the series 
of installment payments is to be treated as a right to a series of 
separate payments. For purposes of this paragraph (b)(2)(iii), a series 
of installment payments refers to an entitlement to the payment of a 
series of substantially equal periodic amounts to be paid over a 
predetermined period of years, except to the extent any increase in the 
amount reflects reasonable earnings through the date the amount is 
paid.
    (iv) Transition rule. For purposes of this section, an arrangement 
that was adopted and effective before December 31, 2006, whether 
written or unwritten,

[[Page 57973]]

that fails to make a designation as to whether the entitlement to a 
series of payments is to be treated as an entitlement to a series of 
separate payments under paragraph (b)(2)(iii) of this section is 
treated as having made such designation as of the later of the date on 
which the arrangement was adopted or became effective, provided that 
such designation is set forth in writing before December 31, 2006.
    (3) Coordination with prohibition against acceleration of payments. 
For purposes of applying the prohibition against the acceleration of 
payments contained in Sec.  1.409A-3(c), the definition of payment is 
the same as the definition provided in paragraph (b)(2) of this 
section. However, even though a change in the form of a payment that 
results in a more rapid schedule for payments generally may not 
constitute an acceleration of a payment, the change in the form of 
payment must comply with the subsequent deferral rules. For example, 
although a change in form from a 10-year installment payment treated as 
a single payment to a lump-sum payment would not constitute an 
acceleration, the change in the form of the payment must still comply 
with the requirements of paragraph (b)(1) of this section, generally 
meaning that the election to change to a lump-sum payment could not be 
effective for 12 months and the lump-sum payment could not be made 
until at least 5 years after the date the installment payments were 
scheduled to commence.
    (4) Application to multiple payment events. In the case of a plan 
that permits a payment upon each of a number of potential permissible 
payment events, such as the earlier of a fixed date or separation from 
service, the requirements of paragraph (b)(1) of this section are 
applied separately to each payment (as defined in paragraph (b)(2) of 
this section) due upon each payment event. Notwithstanding the 
foregoing, the addition of a permissible payment event to amounts 
previously deferred is subject to the rules of this paragraph (b) where 
the addition of the permissible payment event may result in a change in 
the time or form of payment of the amount deferred. For application of 
the rules governing accelerations of payments to the addition of a 
permissible payment event to amounts deferred, see Sec.  1.409A-3.
    (5) Delay of payments under certain circumstances. A plan may 
provide, or be amended to provide, that a payment will be delayed to a 
date after the designated payment date under any of the following 
circumstances, and the provision will not fail to meet the requirements 
of establishing a permissible payment event and the delay in the 
payment will not constitute a subsequent deferral election, provided 
that once such a provision is applicable to an amount of deferred 
compensation, any failure to apply such a provision or modification of 
the plan to remove such a provision will constitute an acceleration of 
any payment to which such provision applied:
    (i) Payments subject to section 162(m). A plan may provide that a 
payment will be delayed where the service recipient reasonably 
anticipates that the service recipient's deduction with respect to such 
payment otherwise would be limited or eliminated by application of 
section 162(m); provided that the terms of the arrangement require the 
payment to be made either at the earliest date at which the service 
recipient reasonably anticipates that the deduction of the payment of 
the amount will not be limited or eliminated by application of section 
162(m) or the calendar year in which the service provider separates 
from service.
    (ii) Payments that would violate a loan covenant or similar 
contractual requirement. A plan may provide that a payment will be 
delayed where the service recipient reasonably anticipates that the 
making of the payment will violate a term of a loan agreement to which 
the service recipient is a party, or other similar contract to which 
the service recipient is a party, and such violation will cause 
material harm to the service recipient; provided that the terms of the 
arrangement require the payment to be made at the earliest date at 
which the service recipient reasonably anticipates that the making of 
the payment will not cause such violation, or such violation will not 
cause material harm to the service recipient, and provided that the 
facts and circumstances indicate that the service recipient entered 
into such loan agreement (including such covenant) or other similar 
contract for legitimate business reasons, and not to avoid the 
restrictions on deferral elections and subsequent deferral elections 
under section 409A.
    (iii) Payments that would violate Federal securities laws or other 
applicable law. A plan may provide that a payment will be delayed where 
the service recipient reasonably anticipates that the making of the 
payment will violate Federal securities laws or other applicable law; 
provided that the terms of the arrangement require the payment to be 
made at the earliest date at which the service recipient reasonably 
anticipates that the making of the payment will not cause such 
violation. For purposes of this paragraph (b)(5)(iii), the making of a 
payment that would cause inclusion in gross income or the application 
of any penalty provision or other provision of the Internal Revenue 
Code is not treated as a violation of applicable law.
    (iv) Other events and conditions. A service recipient may delay a 
payment upon such other events and conditions as the Commissioner may 
prescribe in generally applicable guidance published in the Internal 
Revenue Bulletin.
    (6) Examples. The following examples illustrate the application of 
the provisions of this section:

    Example 1. Initial election to defer salary. Employee A is an 
individual employed by Employer X. Employer X sponsors an 
arrangement under which Employee A may elect to defer a percentage 
of Employee A's salary. Employee A has participated in the 
arrangement in prior years. To satisfy the requirements of this 
section with respect to salary earned in calendar year 2008, if 
Employee A elects to defer any amount of such salary, the deferral 
election (including an election as to the time and form of payment) 
must be made no later than December 31, 2007.
    Example 2. Designation of time and form of payment where an 
initial deferral election is not provided. Employee A is an 
individual employed by Employer X. Employer X has a fiscal year 
ending September 30. On July 1, 2007, Employer X enters into a 
legally binding obligation to pay Employee A a $10,000 bonus. The 
amount is not subject to a substantial risk of forfeiture. Employer 
X does not provide Employee A an election as to the time and form of 
payment. Unless the amount is paid in accordance with the short-term 
deferral rule of Sec.  1.409A-1(b)(4), to satisfy the requirements 
of this section, Employer X must specify the time and form of 
payment on or before July 1, 2007.
    Example 3. Initial election to defer bonus payable based on 
services during calendar year. Employee A is an individual employed 
by Employer X. Employer X has a fiscal year ending September 30. 
Employee A participates in a bonus plan under which Employee A is 
entitled to a bonus for services performed during the calendar year 
that, absent an election by Employee A, will be paid on March 15 of 
the following year. The amount is not subject to a substantial risk 
of forfeiture and does not qualify as performance based 
compensation. If Employee A elects to defer the payment of the bonus 
with respect to calendar year 2008, to satisfy the requirements of 
this paragraph, Employee A must elect the time and form of payment 
not later than December 31, 2007.
    Example 4. Initial election to defer bonus payable based on 
services during fiscal year other than calendar year. Employee A is 
an individual employed by Employer X. Employer X has a fiscal year 
ending September 30. Employee A participates in a bonus plan under 
which Employee A is entitled to a bonus for services performed 
during Employer X's fiscal year that, absent an election by Employee 
A, will be paid on December 15 of the calendar year in which

[[Page 57974]]

the fiscal year ends. The amount is not subject to a substantial 
risk of forfeiture and does not qualify as performance based 
compensation as described in Sec.  1.409A-1(e). The amount qualifies 
as fiscal year compensation. If Employee A elects to defer the 
payment of the amount related to the fiscal year ending September 
30, 2008, to satisfy the requirements of this section Employee A 
must elect the time and form of payment not later than September 30, 
2007.
    Example 5. Initial election to defer bonus payable only if 
service provider completes at least 12 months of services after the 
election. Employee A is an individual employed by Employer X. 
Employer X has a calendar year fiscal year. On March 1, 2006, 
Employer X grants Employee A a $10,000 bonus, payable on March 1, 
2008, provided that Employee A continues performing services as an 
employee of Employer X through March 1, 2008. The amount does not 
qualify as performance-based compensation as described in Sec.  
1.409A-1(e), and Employee A already participates in another account 
balance nonqualified deferred compensation plan. Employee A may make 
an initial deferral election on or before March 31, 2006 (within 30 
days after obtaining a legally binding right), because at least 12 
months of additional services are required after the date of 
election for the risk of forfeiture to lapse.
    Example 6. Initial election to defer bonus that would otherwise 
constitute a short-term deferral. The same facts as Example 5, 
except that Employee A does not make an initial deferral election on 
or before March 31, 2006. Because the right to the compensation 
would not be treated as a deferral of compensation pursuant to Sec.  
1.409A-1(b)(4) absent a deferral election (because the arrangement 
would be treated as a short-term deferral), Employee A may make an 
initial deferral election provided that the election may not become 
effective for 12 months and must defer the payment at least 5 years 
from March 1, 2008 (the first date the payment could become 
substantially vested). Accordingly, Employee A may make an election 
before March 1, 2007, provided that the election defers the payment 
to a date on or after March 1, 2013 (other than a payment due to 
death, disability, unforeseeable emergency, or a change in control 
event).
    Example 7. Initial election to defer commissions. Employee A is 
an individual employed by Employer X. Employer X has a calendar year 
fiscal year. As part of Employee A's services for Employer X, 
Employee A sells refrigerators. Under the employment arrangement, 
Employee A is entitled to 10 percent of the sales price of any 
refrigerator Employee A sells, payable only upon the receipt of 
payment from the customer who purchased the refrigerator. For 
purposes of the initial deferral rule, Employee A is treated as 
performing the services related to each refrigerator sale in the 
taxable year in which each customer pays for the refrigerator.
    Example 8. Initial election to defer renewal commissions. The 
same facts as Example 7, except that Employee A also sells 
warranties related to the refrigerators sold. Under the warranty 
arrangement, refrigerator warranty customers are entitled in a 
future year to extend the warranty for an additional cost to be paid 
at the time of the extension. Under Employee A's arrangement with 
Employer X, Employee A is entitled to 10 percent of the amount paid 
for an extension of any warranty, payable upon the receipt of 
payment from the customer extending the warranty. For purposes of 
the initial deferral rule, Employee A is treated as performing the 
services related to the amount paid for the extension of the 
warranty in the taxable year in which the customer pays for the 
warranty extension.
    Example 9. Initial election to defer negotiated separation pay. 
Employee A is an individual employed by Employer X. Under the terms 
of a separation pay arrangement, Employee A is entitled upon an 
involuntary separation from service to an amount equal to two weeks 
of pay for every year of service at Employer X. Employer X decides 
to terminate Employee A's employment involuntarily. As part of the 
process of terminating Employee A, Employer X enters into bona fide, 
arm's length negotiations with respect to the terms of Employee A's 
termination of employment. As part of the process, Employer X offers 
Employee A an amount that is in addition to any amounts to which 
Employee A is otherwise entitled, payable either as a lump sum 
payment at the end of three years or in three annual payments 
starting at the date of termination of employment. The election of 
the time and form of payment by Employee A may be made at any time 
before Employee A accepts the offer and obtains a legally binding 
right to the additional amount.
    Example 10. Election of time and form of payments under a window 
program. Employee A is an individual employed by Employer X. 
Employer X establishes a window program, as defined in Sec.  1.409A-
1(b)(9)(v). Individuals who elect to terminate employment under the 
window program are entitled to receive an amount equal to two weeks 
pay multiplied by every year of service with Employer X. The 
individuals participating in the window program may elect to receive 
the payment as either a lump sum payment payable on the first day of 
the month after making the election to participate in the window 
program, or as a payment of two equal annual installments on each 
January 1 of the first two years following the election to 
participate in the window program. Employee A is eligible to 
participate in the window program. Employee A may make the election 
as to the time and form of payment on or before the date Employee 
A's election to participate in the window program becomes 
irrevocable.
    Example 11. Initial election to defer salary earned during final 
payroll period beginning in one calendar year and ending in the 
subsequent calendar year. Employee A performs services as an 
employee of Employer X. Employer X pays the salary of its employees, 
including Employee A, on a bi-weekly basis. One bi-weekly payroll 
period runs from December 24, 2006, through January 6, 2007, with a 
scheduled payment date of January 13, 2001. Employer X sponsors, and 
Employee A participates in, a nonqualified deferred compensation 
arrangement under which Employee A may defer a specified percentage 
of his annual salary. The arrangement does not specify that any 
salary compensation paid for the payroll period in which falls 
January 1 is to be treated as compensation for services performed 
during the year preceding the year in which falls that January 1. 
For purposes of applying the initial deferral election rules, 
Employee A is deemed to have performed the services for the payroll 
period December 24, 2006, through January 6, 2007, during the 
calendar year 2007.
    Example 12. Application of deferral election rules and anti-
acceleration rules to a section 401(k) wrap plan. Employee A 
participates in a qualified retirement plan under section 401(a) 
with a qualified cash or deferred arrangement under section 401(k). 
Employee A also participates in a nonqualified deferred compensation 
arrangement. Under the terms of the nonqualified deferred 
compensation arrangement, Employee A elects, on or before December 
31, to defer a specified percentage of his salary for the subsequent 
calendar year. Under the terms of the nonqualified deferred 
compensation arrangement and the qualified plan, as of the earliest 
date administratively practicable following the end of the year in 
which the salary is earned, the maximum amount that may be deferred 
under the qualified cash or deferred arrangement (not in excess of 
the amount specified under section 402(g) for the plan year) is 
credited to Employee A's account under the qualified plan, and 
Employee A's deferral under the nonqualified deferred compensation 
arrangement is reduced by a corresponding amount. The reduction has 
no effect on any other nonqualified deferred compensation 
arrangement in which Employee A participates. The reduction of 
Employee A's account under the nonqualified deferred compensation 
arrangement is not treated as an accelerated payment of deferred 
compensation for purposes of section 409A.
    Example 13. Application of deferral election rules and anti-
acceleration rules to a nonqualified deferred compensation 
arrangement linked to a qualified defined benefit plan. Employee A 
participates in a qualified retirement plan that is a defined 
benefit plan. Employee A also participates in a nonqualified 
deferred compensation arrangement, under which the benefit payable 
is calculated under a formula, with that benefit then reduced by any 
benefit which Employee A has accrued under the qualified retirement 
plan. In 2007, Employee A fails to elect a subsidized benefit under 
the qualified retirement plan, with the effect that the amounts 
payable under the nonqualified deferred compensation arrangement are 
increased relative to the lesser benefit payable under the qualified 
plan. Also, in 2007, Employer X amends the qualified retirement plan 
to increase benefits under the plan, resulting in a relative 
decrease in the amounts payable under the nonqualified deferred 
compensation arrangement relative to the greater benefit payable 
under the qualified plan. Neither of these actions constitute a 
deferral election or an acceleration of a payment under the 
nonqualified deferred compensation arrangement.

[[Page 57975]]

    Example 14. Subsequent deferral election. Employee A 
participates in a nonqualified deferred compensation arrangement. 
Employee A elects to be paid in a lump sum payment at the earlier of 
age 65 or separation from service. Employee A anticipates that he 
will work after age 65, and wishes to defer payment to a later date. 
Provided that Employee A continues in employment and makes the 
election by his 64th birthday, Employee A may elect to receive a 
lump sum payment at the earlier of age 70 or separation from 
service.
    Example 15. Grant of right to current payment of dividends paid 
with respect to restricted stock. Employer X grants Employee A stock 
that is not substantially vested for purposes of section 83, and 
Employee A does not make an election under section 83(b). As part of 
the restricted stock grant, Employee A receives the right to 
payments in an amount equal to the dividends payable with respect to 
the restricted stock. At the time Employer B grants Employee A the 
right to the dividend payments, the grant also specifies that each 
dividend payment will be made no later than the end of the calendar 
year in which the dividends are paid to shareholders of that class 
of stock or, if later, the 15th day of the third month following the 
date the dividends are paid to shareholders of that class of stock. 
The grant of the rights to dividend payments satisfies the 
requirement that deferred amounts be paid at a specified time or 
pursuant to a specified schedule.
    Example 16. Subsequent deferral election rule--change in form of 
payment from lump sum payment to life annuity. Employee A 
participates in a nonqualified deferred compensation arrangement. 
Employee A elects to be paid in a lump sum payment at age 65. 
Employee A wishes to change the payment form to a life annuity. 
Provided that Employee A makes the election on or before his 64th 
birthday, Employee A may elect to receive a life annuity commencing 
at age 70.
    Example 17. Subsequent deferral election rule--change in form of 
payment from life annuity to lump sum payment. Employee A 
participates in a nonqualified deferred compensation arrangement. 
Employee A elects to be paid in a life annuity at age 65. Employee A 
wishes to change the payment form to a lump sum payment. Provided 
that Employee A makes the election on or before his 64th birthday, 
Employee A may elect to receive a lump sum payment at age 70.
    Example 18. Subsequent deferral election rule--installment 
payments designated as separate payments. Employee A participates in 
a nonqualified deferred compensation arrangement that provides for 
payment in a series of 5 equal annual amounts, each designated as a 
separate payment. The first payment is scheduled to be made on 
January 1, 2008. Provided that Employee A makes the election on or 
before January 1, 2007, Employee A may elect for the first payment 
to be made on January 1, 2013. If Employee A makes that election, 
the remaining payments may continue to be due upon January 1 of the 
four calendar years commencing on January 1, 2009.
    Example 19. Subsequent deferral election rule--change in form of 
payment from installment payments to lump sum payment. Employee A 
participates in a nonqualified deferred compensation arrangement 
that provides for payment in a series of 5 equal annual amounts that 
are not designated as a series of 5 separate payments. The first 
amount is scheduled to be paid on January 1, 2008. Employee A wishes 
to receive the entire amount equal to the sum of all five of the 
amounts to be paid as a lump sum payment. Provided that Employee A 
makes the election on or before January 1, 2007, Employee A may 
elect to receive a lump sum payment on or after January 1, 2013.
    Example 20. Subsequent deferral election rule--change in time of 
payment from payment at specified age to payment at later of 
specified age or separation from service. Employee A participates in 
a nonqualified deferred compensation arrangement that provides for a 
lump sum payment at age 65. Employee A wishes to add a payment 
provision such that the payment is payable upon the later of a 
predetermined age or separation from service. Provided that Employee 
A makes such election on or before his 64th birthday, Employee A may 
elect to receive a lump sum payment upon the later of age 70 or 
separation from service.

    (c) Special rules for certain resident aliens. For the first 
calendar year in which an individual is classified as a resident alien, 
a nonqualified deferred compensation arrangement is deemed to meet the 
requirements of paragraph (a) of this section if, with respect to 
compensation payable for services performed during that first calendar 
year or with respect to compensation the right to which is subject to a 
substantial risk of forfeiture as of January 1 of that first calendar 
year, an initial deferral election is made by the end of such first 
calendar year, provided that the initial deferral election may not 
apply to amounts paid or first payable on or before the date of such 
initial deferral election. For any year subsequent to the first 
calendar year in which an individual is classified as a resident alien, 
this paragraph (c) does not apply, provided that a calendar year may 
again be treated as the first calendar year in which an individual is 
classified as a resident alien if such individual has not been 
classified as a resident alien for at least five consecutive calendar 
years immediately preceding the year in which the individual is again 
classified as a resident alien.


Sec.  1.409A-3  Permissible payments.

    (a) In general. The requirements of this section are met only if 
the arrangement provides that an amount of deferred compensation may be 
paid only on account of one or more of the following:
    (1) The service provider's separation from service (as defined in 
Sec.  1.409A-1(h)).
    (2) The service provider becoming disabled (in accordance with 
paragraph (g)(4) of this section).
    (3) The service provider's death.
    (4) A time (or pursuant to a fixed schedule) specified under the 
plan (in accordance with paragraph (g)(1) of this section).
    (5) A change in the ownership or effective control of the 
corporation, or in the ownership of a substantial portion of the assets 
of the corporation (in accordance with paragraph (g)(5) of this 
section).
    (6) The occurrence of an unforeseeable emergency (in accordance 
with paragraph (g)(3) of this section).
    (b) Designation of payment upon a permissible payment event. Except 
as otherwise specified in this section, an arrangement provides for the 
payment upon an event described in paragraph (a)(1), (2), (3), (5) or 
(6) of this section if the arrangement provides for a payment date that 
is objectively determinable at the time the event occurs (for example, 
3 months following the date of initial disability or December 31 of the 
calendar year in which the disability first occurs). In addition, an 
arrangement may provide that a payment is to be made during an 
objectively determinable calendar year following the year in which the 
event occurs (for example, the calendar year following the year in 
which the service provider dies), provided that where no specific date 
within such calendar year is objectively determinable, the payment date 
is deemed to be January 1 of such calendar year for purposes of 
applying the subsequent deferral election rules of Sec.  1.409A-
1(b)(4). An arrangement may provide for payment upon the earliest or 
latest of more than one event, provided that each event is described in 
paragraphs (a)(1) through (6) of this section. An arrangement may also 
provide that a payment upon an event described in paragraph (a)(1), 
(2), (3), (5) or (6) of this section is to be made in accordance with a 
fixed schedule that is objectively determinable based on the date of 
the event, provided that the schedule must be fixed at the time the 
permissible payment event is designated, and any change in the fixed 
schedule will constitute a change in the time and form of payment. For 
example, an arrangement may provide that a service provider is entitled 
to three substantially equal payments payable on each of the first 
three anniversaries of the date of the service provider's separation 
from service. In addition, an arrangement may provide that payments are 
to be made pursuant to a schedule of payments based upon objectively 
determinable calendar years following

[[Page 57976]]

the year in which the event occurs, (for example, three substantially 
equal payments to be made during the three calendar years following the 
year in which the service provider dies), provided that where payment 
dates within such calendar years are not specified under the terms of 
the arrangement, the payment dates are deemed to be January 1 of such 
calendar years for purposes of applying the subsequent deferral 
election rules of Sec.  1.409A-2(b).
    (c) Designation of alternative specified dates or payment schedules 
based upon date of permissible event. In general, in the case of an 
arrangement that provides that a payment upon an event described in 
paragraph (a)(1), (2), (3), (5) or (6) of this section is to be made on 
an objectively determinable date or year in accordance with paragraph 
(b) of this section, or in accordance with a fixed schedule that is 
objectively determinable based on the date of the event in accordance 
with paragraph (b) of this section, the objectively determined date or 
fixed schedule must apply consistently regardless of the date on which 
the specified event occurs. However, an arrangement may allow for an 
alternative payment schedule if the event occurs on or before one (but 
not more than one) specified date. For example, an arrangement may 
provide that a service provider will receive a lump sum payment of the 
service provider's entire benefit under the arrangement on the first 
day of the month following a separation from service before age 55, but 
will receive 5 substantially equal annual payments commencing on the 
first day of the month following a separation from service on or after 
age 55.
    (d) When a payment is treated as made upon the designated payment 
date. Except as otherwise specified in this section, a payment is 
treated as made upon the date specified under the arrangement 
(including a date specified under paragraph (a)(4) of this section) if 
the payment is made at such date or a later date within the same 
calendar year or, if later, by the 15th day of the third calendar month 
following the date specified under the arrangement. If calculation of 
the amount of the payment is not administratively practicable due to 
events beyond the control of the service provider (or service 
provider's estate), the payment will be treated as made upon the date 
specified under the arrangement if the payment is made during the first 
calendar year in which the payment is administratively practicable. 
Similarly, if the funds of the service recipient are not sufficient to 
make the payment at the date specified under the plan without 
jeopardizing the solvency of the service recipient, the payment will be 
treated as made upon the date specified under the arrangement if the 
payment is made during the first calendar year in which the funds of 
the service recipient are sufficient to make the payment without 
jeopardizing the solvency of the service recipient.
    (e) Disputed payments and refusals to pay. If a payment is not 
made, in whole or in part, as of the date specified under the 
arrangement because the service recipient refuses to make such payment, 
the payment will be treated as made upon the date specified under the 
arrangement if the service provider accepts the portion (if any) of the 
payment that the service recipient is willing to make (unless such 
acceptance will result in a forfeiture of the claim to the remaining 
amount), makes prompt and reasonable, good faith efforts to collect the 
payment, and the payment is made during the first calendar year in 
which the service recipient and the service provider enter into a 
legally binding settlement of such dispute, the service recipient 
concedes that the amount is payable, or the service recipient is 
required to make such payment pursuant to a final and nonappealable 
judgment or other binding decision. For purposes of this paragraph (e), 
a service recipient is not treated as having refused to make a payment 
where pursuant to the terms of the plan the service provider is 
required to request payment, or otherwise provide information or take 
any other action, and the service provider has failed to take such 
action. In addition, for purposes of this paragraph (e), the service 
provider is deemed to have requested that a payment not be made, rather 
than the service recipient having refused to make such payment, where 
the service recipient's decision to refuse to make the payment is made 
by the service provider or a member of the service provider's family 
(as defined in section 267(c)(4) applied as if the family of an 
individual includes the spouse of any member of the family), or any 
person or group of persons over whom the service provider or service 
provider's family member has effective control, or any person any 
portion of whose compensation is controlled the service provider or 
service provider's family member.
    (f) Special rule for certain resident aliens. An arrangement that 
is, or constitutes part of, a nonqualified deferred compensation plan 
is deemed to meet the requirements of this section with respect to any 
amount payable in the first calendar year in which a service provider 
is classified as a resident alien, and with respect to any amount 
payable in a subsequent calendar year if no later than the December 31 
of the first calendar year in which the service provider is classified 
as a resident alien, the plan is amended as necessary so that the times 
and forms of payment of amounts payable in a subsequent year comply 
with the provisions of this section. For any year subsequent to the 
first calendar year in which an individual is classified as a resident 
alien, this paragraph (f) does not apply, provided that a calendar year 
may again be treated as the first calendar year in which an individual 
is classified as a resident alien if such individual has not been 
classified as a resident alien for at least five consecutive calendar 
years immediately preceding the year in which the service provider is 
again classified as a resident alien.
    (g) Definitions and special rules--(1) Specified time or fixed 
schedule. Amounts are payable at a specified time or pursuant to a 
fixed schedule if objectively determinable amounts are payable at a 
date or dates that are objectively determinable at the time the amount 
is deferred. An amount is objectively determinable for this purpose if 
the amount is specifically identified or if the amount may be 
determined pursuant to a nondiscretionary formula (for example, 50 
percent of an account balance). A specified time or fixed schedule also 
includes the designation of a calendar year or years that are 
objectively determinable at the time the amount is deferred, provided 
that for purposes of the application of the subsequent deferral rules 
contained in Sec.  1.409A-2(b), the specified time or fixed schedule of 
payments is deemed to refer to January 1 of the relevant calendar year 
or years. An arrangement may provide that a payment upon the lapse of a 
substantial risk of forfeiture is to be made in accordance with a fixed 
schedule that is objectively determinable based on the date the 
substantial risk of forfeiture lapses (disregarding any acceleration of 
the lapsing of the substantial risk of forfeiture other than due to the 
occurrence of a condition applicable as of the date the legally binding 
right to the payment arose that itself would constitute a substantial 
risk of forfeiture), provided that the schedule must be fixed at the 
time the time and form of payment are designated, and any change in the 
fixed schedule will constitute a change in the time and form of 
payment. For example, an arrangement that provides for a bonus

[[Page 57977]]

payment subject to the condition that the service provider complete 
three years of service, but provided further that such requirement of 
continued services would lapse upon the occurrence of an initial public 
offering that if applied alone would subject the right to the payment 
to a substantial risk of forfeiture, may provide that a service 
provider is entitled to substantially equal payments on each of the 
first three anniversaries of the date the substantial risk of 
forfeiture lapses (the earlier of three years of service or the date of 
an initial public offering).
    (2) Required delay in payment to a specified employee pursuant to a 
separation from service. In the case of any specified employee (as 
defined in Sec.  1.409A-1(i)), the requirements of paragraph (a)(1) of 
this section permitting a payment upon a separation from service are 
satisfied only if payments may not be made before the date that is six 
months after the date of separation from service (or, if earlier, the 
date of death of the specified employee). The arrangement must provide 
the manner in which the six-month delay will be implemented in the case 
of a service provider who is a specified employee. For example, an 
arrangement may provide that payments to which a specified employee 
would otherwise be entitled during the first six months following the 
date of separation from service are accumulated and paid at another 
specified date or specified schedule, such as the first date of the 
seventh month following the date of separation from service. The 
arrangement may also provide that each installment payment to which a 
specified employee is entitled upon a separation from service is 
delayed by six months. A service recipient may amend a plan at any time 
to change the method for applying the six-month delay, provided that 
the amendment may not be effective for a period of 12 months. 
Notwithstanding the foregoing, an amendment to a plan may be effective 
immediately in the case of a service recipient that amends the 
arrangement prior to the date upon which the service recipient's stock 
first becomes readily tradable on an established securities market. 
Notwithstanding the foregoing, this paragraph (g)(2) also does not 
apply to a payment made under the circumstances described in paragraph 
(h)(2)(i) (domestic relations order), (h)(2)(ii) (conflicts of 
interest), or (h)(2)(v) (payment of employment taxes) of this section.
    (3) Unforeseeable Emergency--(i) Definition. For purposes of 
paragraph (a)(6) of this section, an unforeseeable emergency is a 
severe financial hardship of the service provider or beneficiary 
resulting from an illness or accident of the service provider or 
beneficiary, the service provider's or beneficiary's spouse, or the 
service provider's or beneficiary's dependent (as defined in section 
152(a)); loss of the service provider's or beneficiary's property due 
to casualty (including the need to rebuild a home following damage to a 
home not otherwise covered by insurance, for example, not as a result 
of a natural disaster); or other similar extraordinary and 
unforeseeable circumstances arising as a result of events beyond the 
control of the service provider or beneficiary. For example, the 
imminent foreclosure of or eviction from the service provider's or 
beneficiary's primary residence may constitute an unforeseeable 
emergency. In addition, the need to pay for medical expenses, including 
non-refundable deductibles, as well as for the costs of prescription 
drug medication, may constitute an unforeseeable emergency. Finally, 
the need to pay for the funeral expenses of a spouse or a dependent (as 
defined in section 152(a)) may also constitute an unforeseeable 
emergency. Except as otherwise provided in this paragraph (g)(3)(i), 
the purchase of a home and the payment of college tuition are not 
unforeseeable emergencies. Whether a service provider or beneficiary is 
faced with an unforeseeable emergency permitting a distribution under 
this paragraph is to be determined based on the relevant facts and 
circumstances of each case, but, in any case, a distribution on account 
of unforeseeable emergency may not be made to the extent that such 
emergency is or may be relieved through reimbursement or compensation 
from insurance or otherwise, by liquidation of the service provider's 
assets, to the extent the liquidation of such assets would not cause 
severe financial hardship, or by cessation of deferrals under the 
arrangement. An arrangement may provide for a payment upon any 
unforeseeable emergency, but does not have to provide for a payment 
upon all unforeseeable emergencies, provided that any event upon which 
a payment may be made qualifies as an unforeseeable emergency.
    (ii) Amount of payment permitted upon an unforeseeable emergency. 
Distributions because of an unforeseeable emergency must be limited to 
the amount reasonably necessary to satisfy the emergency need (which 
may include amounts necessary to pay any Federal, state, or local 
income taxes or penalties reasonably anticipated to result from the 
distribution). Determinations of amounts reasonably necessary to 
satisfy the emergency need must take into account any additional 
compensation that is available if the plan provides for cancellation of 
a deferral election upon a payment due to an unforeseeable emergency. 
See paragraph (h)(2)(vii) of this section. The payment may be made from 
any arrangement in which the service provider participates that 
provides for payment upon an unforeseeable emergency, provided that the 
arrangement under which the payment was made must be designated at the 
time of payment.
    (4) Disability--(i) In general. For purposes of this section, a 
service provider is considered disabled if the service provider meets 
one of the following requirements:
    (A) The service provider is unable to engage in any substantial 
gainful activity by reason of any medically determinable physical or 
mental impairment that can be expected to result in death or can be 
expect to last for a continuous period of not less than 12 months.
    (B) The service provider is, by reason of any medically 
determinable physical or mental impairment that can be expected to 
result in death or can be expected to last for a continuous period of 
not less than 12 months, receiving income replacement benefits for a 
period of not less than 3 months under an accident and health plan 
covering employees of the service provider's employer.
    (ii) Limited plan definition of disability. An arrangement may 
provide for a payment upon any disability, and need not provide for a 
payment upon all disabilities, provided that any disability upon which 
a payment may be made under the arrangement complies with the 
provisions of this paragraph (g)(4).
    (iii) Determination of disability. An arrangement may provide that 
a service provider will be deemed disabled if determined to be totally 
disabled by the Social Security Administration. An arrangement may also 
provide that a service provider will be deemed disabled if determined 
to be disabled in accordance with a disability insurance program, 
provided that the definition of disability applied under such 
disability insurance program complies with the requirements of this 
paragraph (g)(4).
    (5) Change in the ownership or effective control of a corporation, 
or a change in the ownership of a substantial portion of the assets of 
a corporation--(i) In general. Pursuant to section 409A(a)(2)(A)(v), an 
arrangement may permit a payment upon the occurrence of a change in the 
ownership of the

[[Page 57978]]

corporation (as defined in paragraph (g)(5)(v) of this section), a 
change in effective control of the corporation (as defined in paragraph 
(g)(5)(vi) of this section), or a change in the ownership of a 
substantial portion of the assets of the corporation (as defined in 
paragraph (g)(5)(vii) of this section) (collectively referred to as a 
change in control event). To qualify as a change in control event, the 
occurrence of the event must be objectively determinable and any 
requirement that any other person, such as a plan administrator or 
board of directors compensation committee, certify the occurrence of a 
change in control event must be strictly ministerial and not involve 
any discretionary authority. The arrangement may provide for a payment 
on any change in control event, and need not provide for a payment on 
all such events, provided that each event upon which a payment is 
provided qualifies as a change in control event. For rules regarding 
the ability of the service recipient to terminate the arrangement and 
pay amounts of deferred compensation upon a change in control event, 
see paragraph (h)(2)(viii)(B) of this section.
    (ii) Identification of relevant corporation--(A) In general. To 
constitute a change in control event as to the service provider, the 
change in control event must relate to--
    (1) The corporation for whom the service provider is performing 
services at the time of the change in control event;
    (2) The corporation that is liable for the payment of the deferred 
compensation (or all corporations liable for the payment if more than 
one corporation is liable); or
    (3) A corporation that is a majority shareholder of a corporation 
identified in paragraph (g)(5)(ii)(A)(1) or (2) of this section, or any 
corporation in a chain of corporations in which each corporation is a 
majority shareholder of another corporation in the chain, ending in a 
corporation identified in paragraph (g)(5)(ii)(A)(1) or (2) of this 
section.
    (B) Majority shareholder. For purposes of this paragraph 
(g)(5)(ii), a majority shareholder is a shareholder owning more than 50 
percent of the total fair market value and total voting power of such 
corporation.
    (C) Example. The following example illustrates the rules of this 
paragraph (g)(5)(ii):

    Example. Corporation A is a majority shareholder of Corporation 
B, which is a majority shareholder of Corporation C. A change in 
ownership of Corporation B constitutes a change in control event to 
service providers performing services for Corporation B or 
Corporation C, and to service providers for which Corporation B or 
Corporation C is solely liable for payments under the plan (for 
example, former employees), but is not a change in control event as 
to Corporation A or any other corporation of which Corporation A is 
a majority shareholder. Notwithstanding the foregoing, a sale of 
Corporation B may constitute an independent change in control event 
for Corporation A, Corporation B and Corporation C if the sale 
constitutes a change in the ownership of a substantial portion of 
Corporation A's assets (see paragraph (g)(5)(vii) of this section).

    (iii) Attribution of stock ownership. For purposes of paragraph 
(g)(5) of this section, section 318(a) applies to determine stock 
ownership. Stock underlying a vested option is considered owned by the 
individual who holds the vested option (and the stock underlying an 
unvested option is not considered owned by the individual who holds the 
unvested option). For purposes of the preceding sentence, however, if a 
vested option is exercisable for stock that is not substantially vested 
(as defined by Sec.  1.83-3(b) and (j)), the stock underlying the 
option is not treated as owned by the individual who holds the option.
    (iv) Special rule for certain delayed payments pursuant to a change 
in control event. Compensation payable pursuant to the purchase by the 
service recipient of service recipient stock or a stock right held by a 
service provider, or payment of amounts of deferred compensation 
calculated by reference to the value of service recipient stock, may be 
treated as paid at a specified time or pursuant to a fixed schedule in 
conformity with the requirements of section 409A if paid on the same 
schedule and under the same terms and conditions as payments to 
shareholders generally pursuant to a change in control event described 
in paragraph (g)(5)(v) of this section (change in the ownership of a 
corporation) or as payments to the service recipient pursuant to a 
change in control event described in paragraph (g)(5)(vii) of this 
section (change in the ownership of a substantial portion of a 
corporation's assets), and any amounts paid pursuant to such a schedule 
and such terms and conditions will not be treated as violating the 
initial or subsequent deferral elections rules, to the extent that such 
amounts are paid not later than five years after the change in control 
event.
    (v) Change in the ownership of a corporation--(A) In general. For 
purposes of section 409A, a change in the ownership of a corporation 
occurs on the date that any one person, or more than one person acting 
as a group (as defined in paragraph (g)(5)(v)(B) of this section), 
acquires ownership of stock of the corporation that, together with 
stock held by such person or group, constitutes more than 50 percent of 
the total fair market value or total voting power of the stock of such 
corporation. However, if any one person, or more than one person acting 
as a group, is considered to own more than 50 percent of the total fair 
market value or total voting power of the stock of a corporation, the 
acquisition of additional stock by the same person or persons is not 
considered to cause a change in the ownership of the corporation (or to 
cause a change in the effective control of the corporation (within the 
meaning of paragraph (g)(5)(vi) of this section)). An increase in the 
percentage of stock owned by any one person, or persons acting as a 
group, as a result of a transaction in which the corporation acquires 
its stock in exchange for property will be treated as an acquisition of 
stock for purposes of this section. This section applies only when 
there is a transfer of stock of a corporation (or issuance of stock of 
a corporation) and stock in such corporation remains outstanding after 
the transaction (see paragraph (g)(5)(vii) of this section for rules 
regarding the transfer of assets of a corporation).
    (B) Persons acting as a group. For purposes of paragraph 
(g)(5)(v)(A) of this section, persons will not be considered to be 
acting as a group solely because they purchase or own stock of the same 
corporation at the same time, or as a result of the same public 
offering. However, persons will be considered to be acting as a group 
if they are owners of a corporation that enters into a merger, 
consolidation, purchase or acquisition of stock, or similar business 
transaction with the corporation. If a person, including an entity, 
owns stock in both corporations that enter into a merger, 
consolidation, purchase or acquisition of stock, or similar 
transaction, such shareholder is considered to be acting as a group 
with other shareholders in a corporation prior to the transaction 
giving rise to the change and not with respect to the ownership 
interest in the other corporation. See Sec.  1.280G-1, Q&A-27(d), 
Example 4.
    (vi) Change in the effective control of a corporation--(A) In 
general. For purposes of section 409A, notwithstanding that a 
corporation has not undergone a change in ownership under paragraph 
(g)(5)(v) of this section, a change in the effective control of a 
corporation occurs only on the date that either--

[[Page 57979]]

    (1) Any one person, or more than one person acting as a group (as 
determined under paragraph (g)(5)(v)(B) of this section), acquires (or 
has acquired during the 12-month period ending on the date of the most 
recent acquisition by such person or persons) ownership of stock of the 
corporation possessing 35 percent or more of the total voting power of 
the stock of such corporation; or
    (2) A majority of members of the corporation's board of directors 
is replaced during any 12-month period by directors whose appointment 
or election is not endorsed by a majority of the members of the 
corporation's board of directors prior to the date of the appointment 
or election, provided that for purposes of this paragraph (g)(5)(vi)(A) 
the term corporation refers solely to the relevant corporation 
identified in paragraph (g)(5)(ii) of this section, for which no other 
corporation is a majority shareholder for purposes of that paragraph 
(for example, if Corporation A is a publicly held corporation with no 
majority shareholder, and Corporation A is the majority shareholder of 
Corporation B, which is the majority shareholder of Corporation C, the 
term corporation for purposes of this paragraph (g)(5)(vi)(A)(2) would 
refer solely to Corporation A).
    (B) Multiple change in control events. A change in effective 
control also may occur in any transaction in which either of the two 
corporations involved in the transaction has a change in control event 
under paragraphs (g)(5)(v) or (g)(5)(vii) of this section. Thus, for 
example, assume Corporation P transfers more than 40 percent of the 
total gross fair market value of its assets to Corporation O in 
exchange for 35 percent of O's stock. P has undergone a change in 
ownership of a substantial portion of its assets under paragraph 
(g)(5)(vii) of this section and O has a change in effective control 
under this paragraph (g)(5)(vi) of this section.
    (C) Acquisition of additional control. If any one person, or more 
than one person acting as a group, is considered to effectively control 
a corporation (within the meaning of this paragraph (g)(5)(vi)), the 
acquisition of additional control of the corporation by the same person 
or persons is not considered to cause a change in the effective control 
of the corporation (or to cause a change in the ownership of the 
corporation within the meaning of paragraph (g)(5)(v) of this section).
    (D) Persons acting as a group. Persons will not be considered to be 
acting as a group solely because they purchase or own stock of the same 
corporation at the same time, or as a result of the same public 
offering. However, persons will be considered to be acting as a group 
if they are owners of a corporation that enters into a merger, 
consolidation, purchase or acquisition of stock, or similar business 
transaction with the corporation. If a person, including an entity, 
owns stock in both corporations that enter into a merger, 
consolidation, purchase or acquisition of stock, or similar 
transaction, such shareholder is considered to be acting as a group 
with other shareholders in a corporation only with respect to the 
ownership in that corporation prior to the transaction giving rise to 
the change and not with respect to the ownership interest in the other 
corporation. See Sec.  1.280G-1, Q&A-27(d), Example 4.
    (vii) Change in the ownership of a substantial portion of a 
corporation's assets--(A) In general. Change in the ownership of a 
substantial portion of a corporation's assets. For purposes of section 
409A, a change in the ownership of a substantial portion of a 
corporation's assets occurs on the date that any one person, or more 
than one person acting as a group (as determined in paragraph 
(g)(5)(v)(B) of this section), acquires (or has acquired during the 12-
month period ending on the date of the most recent acquisition by such 
person or persons) assets from the corporation that have a total gross 
fair market value equal to or more than 40 percent of the total gross 
fair market value of all of the assets of the corporation immediately 
prior to such acquisition or acquisitions. For this purpose, gross fair 
market value means the value of the assets of the corporation, or the 
value of the assets being disposed of, determined without regard to any 
liabilities associated with such assets.
    (B) Transfers to a related person--(1) There is no change in 
control event under this paragraph (g)(5)(vii) when there is a transfer 
to an entity that is controlled by the shareholders of the transferring 
corporation immediately after the transfer, as provided in this 
paragraph (g)(5)(vii)(B). A transfer of assets by a corporation is not 
treated as a change in the ownership of such assets if the assets are 
transferred to--
    (i) A shareholder of the corporation (immediately before the asset 
transfer) in exchange for or with respect to its stock;
    (ii) An entity, 50 percent or more of the total value or voting 
power of which is owned, directly or indirectly, by the corporation;
    (iii) A person, or more than one person acting as a group, that 
owns, directly or indirectly, 50 percent or more of the total value or 
voting power of all the outstanding stock of the corporation; or
    (iv) An entity, at least 50 percent of the total value or voting 
power of which is owned, directly or indirectly, by a person described 
in paragraph (g)(5)(vii)(B)(1)(iii) of this section.
    (2) For purposes of this paragraph (g)(5)(vii)(B) and except as 
otherwise provided, a person's status is determined immediately after 
the transfer of the assets. For example, a transfer to a corporation in 
which the transferor corporation has no ownership interest before the 
transaction, but which is a majority-owned subsidiary of the transferor 
corporation after the transaction is not treated as a change in the 
ownership of the assets of the transferor corporation.
    (C) Persons acting as a group. Persons will not be considered to be 
acting as a group solely because they purchase assets of the same 
corporation at the same time. However, persons will be considered to be 
acting as a group if they are owners of a corporation that enters into 
a merger, consolidation, purchase or acquisition of assets, or similar 
business transaction with the corporation. If a person, including an 
entity shareholder, owns stock in both corporations that enter into a 
merger, consolidation, purchase or acquisition of assets, or similar 
transaction, such shareholder is considered to be acting as a group 
with other shareholders in a corporation only to the extent of the 
ownership in that corporation prior to the transaction giving rise to 
the change and not with respect to the ownership interest in the other 
corporation. See 1.280G-1, Q&A-27(d), Example 4.
    (6) Certain back-to-back arrangements--(i) In general. 
Notwithstanding the generally applicable limitations on payments 
described under paragraph (a) of this section, an arrangement between a 
service recipient and a service provider that is also a service 
recipient (a service provider/service recipient) may provide for 
payment upon the occurrence of a payment event described in paragraph 
(a)(1), (2), (3), (5) or (6) of this section, where the time and form 
of payment is defined as the same time and form of payment provided 
under an arrangement subject to section 409A between the service 
provider/service recipient and a specified service provider to the 
service provider/service recipient, if the arrangement between the 
service provider/service recipient and the service recipient expressly 
provides for such time and form of payment and otherwise satisfies the 
requirements of section 409A.

[[Page 57980]]

    (ii) Example. The provisions of this paragraph (g)(6) are 
illustrated by the following example:

    Example. Company B (service provider/service recipient) provides 
services to Company C (service recipient). Employee A (service 
provider) provides services to Company B. Pursuant to a nonqualified 
deferred compensation plan meeting the requirements of section 409A, 
Employee A is entitled to a payment of deferred compensation upon a 
separation from service from Company B. Under an arrangement between 
Company B and Company C, Company C agrees to pay an amount of 
deferred compensation to Company B upon Employee A's separation from 
service from Company B, in accordance with the time and form of 
payment provided in the nonqualified deferred compensation plan 
between Employee A and Company B. Provided that the arrangement 
between Company B and Company C and the arrangement between Employee 
A and Company B otherwise comply with the requirements of section 
409A, Company C's payment to Company B of the amount due upon the 
separation from service of Employee A from Company B may constitute 
a permissible payment event for purposes of paragraph (a) of this 
section.

    (h) Prohibition on acceleration of payments--(1) In general. Except 
as provided in paragraph (h)(2) of this section, an arrangement that 
is, or constitutes part of, a nonqualified deferred compensation plan 
may not permit the acceleration of the time or schedule of any payment 
or amount scheduled to be paid pursuant to a payment under the 
arrangement. For purposes of this paragraph (h), an impermissible 
acceleration does not occur if payment is made in accordance with plan 
provisions or an election as to the time and form of payment in effect 
at the time of initial deferral (or added in accordance with the rules 
applicable to subsequent deferral elections under Sec.  1.409A-2(b)) 
pursuant to which payment is required to be made on an accelerated 
schedule as a result of an intervening event that is an event described 
in paragraph (a)(1), (2), (3), (5) or (6) of this section. For example, 
a plan may provide that a participant will receive six installment 
payments commencing at separation from service, and also provide that 
if the participant dies after such payments commence but before all 
payments have been made, all remaining amounts will be paid in a lump 
sum payment. Additionally, it is not an acceleration of the time or 
schedule of payment of a deferral of compensation if a service 
recipient waives or accelerates the satisfaction of a condition 
constituting a substantial risk of forfeiture applicable to such 
deferral of compensation, provided that the requirements of section 
409A (including the requirement that the payment be made upon a 
permissible payment event) are otherwise satisfied with respect to such 
deferral of compensation. For example, if a nonqualified deferred 
compensation arrangement provides for a lump sum payment of the vested 
benefit upon separation from service, and the benefit vests under the 
plan only after 10 years of service, it is not a violation of the 
requirements of section 409A if the service recipient reduces the 
vesting requirement to 5 years of service, even if a service provider 
becomes vested as a result and receives a payment in connection with a 
separation from service before the service provider would have 
completed 10 years of service.
    (2) Exceptions--(i) Domestic relations order. An arrangement may 
permit such acceleration of the time or schedule of a payment under the 
arrangement to an individual other than the service provider as may be 
necessary to fulfill a domestic relations order (as defined in section 
414(p)(1)(B)).
    (ii) Conflicts of interest. An arrangement may permit such 
acceleration of the time or schedule of a payment under the arrangement 
as may be necessary to comply with a certificate of divestiture (as 
defined in section 1043(b)(2)).
    (iii) Section 457 plans. An arrangement subject to section 457(f) 
may permit an acceleration of the time or schedule of a payment to a 
service provider to pay Federal, state, local and foreign income taxes 
due upon a vesting event, provided that the amount of such payment is 
not more than an amount equal to the Federal, state, local and foreign 
income tax withholding that would have been remitted by the employer if 
there had been a payment of wages equal to the income includible by the 
service provider under section 457(f) at the time of the vesting.
    (iv) De minimis and specified amounts--(A) In general. An 
arrangement that does not otherwise provide for mandatory lump sum 
payments of benefits that do not exceed a specified amount may be 
amended to permit the acceleration of the time or schedule of a payment 
to a service provider under the arrangement, provided that--
    (1) The payment accompanies the termination of the entirety of the 
service provider's interest in the arrangement, and all similar 
arrangements that would constitute a nonqualified deferred compensation 
plan under Sec.  1.409A-1(c);
    (2) The payment is made on or before the later of December 31 of 
the calendar year in which occurs the service provider's separation 
from service from the service recipient, or the 15th day of the third 
month following the service provider's separation from service from the 
service recipient;
    (3) The payment is not greater than $10,000; and
    (4) The participant is provided no election with respect to receipt 
of the lump sum payment.
    (B) Prospective deferrals. An amendment described in paragraph 
(h)(2)(iv)(A) of this section may be made with respect to previously 
deferred amounts under the arrangement as well as amounts to be 
deferred in the future. In addition, a nonqualified deferred 
compensation arrangement that otherwise complies with section 409A may 
provide, or be amended with regard to future deferrals to provide, 
that, if a service provider's interest under the arrangement has a 
value below an amount specified by the plan at the time that amounts 
are payable under the plan, then the service provider's entire interest 
under the plan must be distributed as a lump sum payment. However, once 
such a payment feature applies to an amount deferred, any change or 
elimination of such feature is subject to the rules governing changes 
in the time and form of payment.
    (v) Payment of employment taxes. An arrangement may permit the 
acceleration of the time or schedule of a payment to pay the Federal 
Insurance Contributions Act (FICA) tax imposed under section 3101, 
section 3121(a) and section 3121(v)(2), where applicable, on 
compensation deferred under the arrangement (the FICA Amount). 
Additionally, an arrangement may permit the acceleration of the time or 
schedule of a payment to pay the income tax at source on wages imposed 
under section 3401 or the corresponding withholding provisions of 
applicable state, local, or foreign tax laws as a result of the payment 
of the FICA Amount, and to pay the additional income tax at source on 
wages attributable to the pyramiding section 3401 wages and taxes. 
However, the total payment under this acceleration provision must not 
exceed the aggregate of the FICA Amount, and the income tax withholding 
related to such FICA Amount.
    (vi) Payments upon income inclusion under section 409A. An 
arrangement may permit the acceleration of the time or schedule of a 
payment to a service provider under the plan at any time the 
arrangement fails to meet the requirements of section 409A and these 
regulations. Such payment may not exceed the amount required to be 
included in income as a result of the

[[Page 57981]]

failure to comply with the requirements of section 409A and the 
regulations.
    (vii) Cancellation of deferrals following an unforeseeable 
emergency or hardship distribution. An arrangement may permit a 
cancellation of a service provider's deferral election due to an 
unforeseeable emergency or a hardship distribution pursuant to Sec.  
1.401(k)-1(d)(3). The deferral election must be cancelled, and not 
postponed or otherwise delayed, such that any later deferral election 
will be subject to the provisions governing initial deferral elections. 
See Sec.  1.409A-2(a).
    (viii) Arrangement terminations. An arrangement may permit an 
acceleration of the time and form of a payment where the right to the 
payment arises due to a termination of the arrangement in accordance 
with one of the following:
    (A) The service recipient's discretion under the terms of the 
arrangement to terminate the arrangement within 12 months of a 
corporate dissolution taxed under section 331, or with the approval of 
a bankruptcy court pursuant to 11 U.S.C. 503(b)(1)(A), provided that 
the amounts deferred under the plan are included in the participants' 
gross incomes in the latest of--
    (1) The calendar year in which the plan termination occurs;
    (2) The calendar year in which the amount is no longer subject to a 
substantial risk of forfeiture; or
    (3) The first calendar year in which the payment is 
administratively practicable.
    (B) The service recipient's discretion under the terms of the 
arrangement to terminate the arrangement within the 30 days preceding 
or the 12 months following a change in control event (as defined in 
Sec.  1.409A-2(g)(4)(i)). For purposes of this paragraph (h)(2)(viii), 
an arrangement will be treated as terminated only if all substantially 
similar arrangements sponsored by the service recipient are terminated, 
so that the participant in the arrangement and all participants under 
substantially similar arrangements are required to receive all amounts 
of compensation deferred under the terminated arrangements within 12 
months of the date of termination of the arrangements.
    (C) The service recipient's discretion under the terms of the 
arrangement to terminate the arrangement, provided that--
    (1) All arrangements sponsored by the service recipient that would 
be aggregated with any terminated arrangement under Sec.  1.409A-1(c) 
if the same service provider participated in all of the arrangements 
are terminated;
    (2) No payments other than payments that would be payable under the 
terms of the arrangements if the termination had not occurred are made 
within 12 months of the termination of the arrangements;
    (3) All payments are made within 24 months of the termination of 
the arrangements; and
    (4) The service recipient does not adopt a new arrangement that 
would be aggregated with any terminated arrangement under Sec.  1.409A-
1(c) if the same service provider participated in both arrangements, at 
any time within five years following the date of termination of the 
arrangement.
    (D) Such other events and conditions as the Commissioner may 
prescribe in generally applicable guidance published in the Internal 
Revenue Bulletin (see Sec.  601.601(d)(2) of this chapter).
    (ix) Certain distributions to avoid a nonallocation year under 
section 409(p). An arrangement may provide for an acceleration of 
payment to prevent the occurrence of a nonallocation year (within the 
meaning of section 409(p)(3)) in the plan year of the employee stock 
ownership plan next following the current plan year, provided that the 
amount distributed may not exceed 125 percent of the minimum amount of 
distribution necessary to avoid the occurrence of a nonallocation year. 
Solely for purposes of determining permissible distributions under this 
paragraph (h)(2)(ix), synthetic equity (within the meaning of section 
409(p)(6)(C)) granted during the current employee stock ownership plan 
plan year is disregarded for purposes of determining whether the 
subsequent plan year would result in a nonallocation year.
    (3) Nonqualified deferred compensation arrangements linked to 
qualified plans. With respect to amounts deferred under an arrangement 
that is, or constitutes part of, a nonqualified deferred compensation 
plan, where under the terms of the nonqualified deferred compensation 
arrangement the amount deferred under the plan is the amount determined 
under the formula determining benefits under a qualified employer plan 
(as defined in Sec.  1.409A-1(a)(2)) applied without respect to one or 
more limitations applicable to qualified employer plans under the 
Internal Revenue Code or other applicable law, or is determined as an 
amount offset by some or all of the benefits provided under the 
qualified employer plan, the operation of the qualified employer plan 
with respect to changes in benefit limitations applicable to qualified 
employer plans under the Internal Revenue Code or other applicable law, 
does not constitute an acceleration of a payment under the nonqualified 
deferred compensation arrangement regardless of whether such operation 
results in a decrease of amounts deferred under the nonqualified 
deferred compensation arrangement. In addition, with respect to such 
nonqualified deferred compensation arrangements, the following actions 
or failures to act will not constitute an acceleration of a payment 
under the nonqualified deferred compensation arrangement regardless of 
whether in accordance with the terms of the nonqualified deferred 
compensation arrangement, the actions or inactions result in a decrease 
in the amounts deferred under the arrangement:
    (i) A service provider's action or inaction under the qualified 
employer plan with respect to whether to elect to receive a subsidized 
benefit or an ancillary benefit under the qualified employer plan.
    (ii) The amendment of a qualified employer plan to increase 
benefits provided under the qualified plan, or to add or remove a 
subsidized benefit or an ancillary benefit.
    (iii) A service provider's action or inaction with respect to an 
elective deferral election under a qualified employer plan subject to 
section 402(g), including an adjustment to a deferral election made 
during a calendar year, provided that for any given calendar year, the 
service provider's actions or inactions do not result in a decrease in 
the amounts deferred under all nonqualified deferred compensation plans 
in which the service provider participates in excess of an amount equal 
to the limit with respect to elective deferrals under section 402(g) in 
effect for the taxable year in which such action or inaction occurs.
    (iv) A service provider's action or inaction under a qualified 
employer plan with respect to elective deferrals or after-tax 
contributions by the service provider to the qualified employer plan 
that affects the amounts that are credited under a nonqualified 
deferred compensation arrangement as matching amounts or other amounts 
contingent on service provider elective deferrals or after-tax 
contributions, provided that such matching or contingent amounts, as 
applicable, are either forfeited or never credited under the 
nonqualified deferred compensation arrangement in the absence of such 
service provider's elective deferral or after-tax contribution, and 
provided further that for any given calendar year, the service 
provider's actions and inactions do not result in a decrease in the 
amounts deferred under all nonqualified deferred compensation plans in 
which the

[[Page 57982]]

service provider participates in excess of an amount equal to the limit 
with respect to elective deferrals under section 402(g) in effect for 
the taxable year in which such action or inaction occurs. See Sec.  
1.409A-2(b)(6), Example 12 and Example 13.


Sec.  1.409A-4 Calculation of income inclusion.  [Reserved].


Sec.  1.409A-5 Funding.  [Reserved].


Sec.  1.409A-6  Statutory effective dates.

    (a) Statutory effective dates --(1) In general. Except as otherwise 
provided in this section, section 409A is effective with respect to 
amounts deferred in taxable years beginning after December 31, 2004, 
and amounts deferred in taxable years beginning before January 1, 2005, 
if the plan under which the deferral is made is materially modified 
after October 3, 2004. Section 409A is effective with respect to 
earnings on amounts deferred only to the extent that section 409A is 
effective with respect to the amounts deferred. Accordingly, section 
409A is not effective with respect to earnings on amounts deferred 
before January 1, 2005, unless section 409A is effective with respect 
to the amounts deferred.
    (2) Identification of date of deferral for statutory effective date 
purposes. For purposes of determining whether section 409A is 
applicable with respect to an amount, the amount is considered deferred 
before January 1, 2005, if before January 1, 2005, the service provider 
had a legally binding right to be paid the amount, and the right to the 
amount was earned and vested. For purposes of this paragraph (a)(2), a 
right to an amount was earned and vested only if the amount was not 
subject to a substantial risk of forfeiture (as defined in Sec.  1.83-
3(c)) or a requirement to perform further services. Amounts to which 
the service provider did not have a legally binding right before 
January 1, 2005 (for example because the service recipient retained 
discretion to reduce the amount), will not be considered deferred 
before January 1, 2005. In addition, amounts to which the service 
provider had a legally binding right before January 1, 2005, but the 
right to which was subject to a substantial risk of forfeiture or a 
requirement to perform further services after December 31, 2004, are 
not considered deferred before January 1, 2005, for purposes of the 
effective date. Notwithstanding the foregoing, an amount to which the 
service provider had a legally binding right before January 1, 2005, 
but for which the service provider was required to continue performing 
services to retain the right only through the completion of the payroll 
period (as defined in Sec.  1.409A-1(b)(3)) that includes December 31, 
2004, is not treated as subject to a requirement to perform further 
services (or a substantial risk of forfeiture) for purposes of the 
effective date. For purposes of this paragraph (a)(2), a stock option, 
stock appreciation right or similar compensation that on or before 
December 31, 2004, was immediately exercisable for cash or 
substantially vested property (as defined in Sec.  1.83-3(b)) is 
treated as earned and vested, regardless of whether the right would 
terminate if the service provider ceased providing services for the 
service recipient.
    (3) Calculation of amount of compensation deferred for statutory 
effective date purposes--(i) Nonaccount balance plans. The amount of 
compensation deferred before January 1, 2005, under a nonqualified 
deferred compensation plan that is a nonaccount balance plan (as 
defined in Sec.  31.3121(v)(2)-1(c)(2)(i) of this chapter) equals the 
present value as of December 31, 2004, of the amount to which the 
service provider would be entitled under the plan if the service 
provider voluntarily terminated services without cause on December 31, 
2004, and received a payment of the benefits with the maximum value 
available from the plan on the earliest possible date allowed under the 
plan to receive a payment of benefits following the termination of 
services. Notwithstanding the foregoing, for any subsequent calendar 
year, the grandfathered amount may increase to equal the present value 
of the benefit the service provider actually becomes entitled to, 
determined under the terms of the plan (including applicable limits 
under the Internal Revenue Code), as in effect on October 3, 2004, 
without regard to any further services rendered by the service provider 
after December 31, 2004, or any other events affecting the amount of or 
the entitlement to benefits (other than a participant election with 
respect to the time or form of an available benefit).
    (ii) Account balance plans. The amount of compensation deferred 
before January 1, 2005, under a nonqualified deferred compensation plan 
that is an account balance plan (as defined in Sec.  31.3121(v)(2)-
1(c)(1)(ii) of this chapter) equals the portion of the service 
provider's account balance as of December 31, 2004, the right to which 
is earned and vested (as defined in paragraph (a)(2) of this section) 
as of December 31, 2004.
    (iii) Equity-based compensation plans. For purposes of determining 
the amounts deferred before January 1, 2005, under an equity-based 
compensation plan, the rules of paragraph (a)(3)(ii) of this section 
governing account balance plans are applied except that the account 
balance is deemed to be the amount of the payment available to the 
service provider on December 31, 2004 (or that would be available to 
the service provider if the right were immediately exercisable) the 
right to which is earned and vested (as defined in paragraph (a)(2) of 
this section) as of December 31, 2004. For this purpose, the payment 
available to the service provider excludes any exercise price or other 
amount that must be paid by the service provider.
    (iv) Earnings. Earnings on amounts deferred under a plan before 
January 1, 2005, include only income (whether actual or notional) 
attributable to the amounts deferred under a plan as of December 31, 
2004, or such income. For example, notional interest earned under the 
plan on amounts deferred in an account balance plan as of December 31, 
2004, generally will be treated as earnings on amounts deferred under 
the plan before January 1, 2005. Similarly, an increase in the amount 
of payment available pursuant to a stock option, stock appreciation 
right or other equity-based compensation above the amount of payment 
available as of December 31, 2004, due to appreciation in the 
underlying stock after December 31, 2004, or accrual of other earnings 
such as dividends, is treated as earnings on the amount deferred. In 
the case of a nonaccount balance plan, earnings include the increase, 
due solely to the passage of time, in the present value of the future 
payments to which the service provider has obtained a legally binding 
right, the present value of which constituted the amounts deferred 
under the plan before January 1, 2005. Thus, for each year, there will 
be an increase (determined using the same interest rate used to 
determine the amounts deferred under the plan before January 1, 2005) 
resulting from the shortening of the discount period before the future 
payments are made, plus, if applicable, an increase in the present 
value resulting from the service provider's survivorship during the 
year. However, an increase in the potential benefits under a nonaccount 
balance plan due to, for example, an application of an increase in 
compensation after December 31, 2004, to a final average pay plan or 
subsequent eligibility for an early retirement subsidy, does not 
constitute earnings on the amounts deferred under the plan before 
January 1, 2005.

[[Page 57983]]

    (v) Definition of plan. For purposes of this paragraph (a), the 
term plan has the same meaning provided in Sec.  1.409A-1(c), except 
that the provisions treating all nonaccount balance plans under which 
compensation is deferred as a single plan does not apply for purposes 
of the actuarial assumptions used in paragraph (a)(3)(ii) of this 
section. Accordingly, different reasonable actuarial assumptions may be 
used to calculate the amounts deferred by a service provider in two 
different arrangements each of which constitutes a nonaccount balance 
plan.
    (4) Material modifications--(i) In general. Except as otherwise 
provided, a modification of a plan is a material modification if a 
benefit or right existing as of October 3, 2004, is materially enhanced 
or a new material benefit or right is added, and such material 
enhancement or addition affects amounts earned and vested before 
January 1, 2005. Such material benefit enhancement or addition is a 
material modification whether it occurs pursuant to an amendment or the 
service recipient's exercise of discretion under the terms of the plan. 
For example, an amendment to a plan to add a provision that payments of 
deferred amounts earned and vested before January 1, 2005, may be 
allowed upon request if service providers are required to forfeit 20 
percent of the amount of the payment (a haircut) would be a material 
modification to the plan. Similarly, a material modification would 
occur if a service recipient exercised discretion to accelerate vesting 
of a benefit under the plan to a date on or before December 31, 2004. 
However, it is not a material modification for a service recipient to 
exercise discretion over the time and manner of payment of a benefit to 
the extent such discretion is provided under the terms of the plan as 
of October 3, 2004. It is not a material modification for a service 
provider to exercise a right permitted under the plan as in effect on 
October 3, 2004. The amendment of a plan to bring the plan into 
compliance with the provisions of section 409A will not be treated as a 
material modification. However, a plan amendment or the exercise of 
discretion under the terms of the plan that materially enhances an 
existing benefit or right or adds a new material benefit or right will 
be considered a material modification even if the enhanced or added 
benefit would be permitted under section 409A. For example, the 
addition of a right to a payment upon an unforeseeable emergency of an 
amount earned and vested before January 1, 2005, would be considered a 
material modification. The reduction of an existing benefit is not a 
material modification. For example, the removal of a haircut provision 
generally would not constitute a material modification. The 
establishment of or contributions to a trust or other arrangement from 
which benefits under the plan are to be paid is not a material 
modification of the plan, provided that the contribution to the trust 
or other arrangement would not otherwise cause an amount to be 
includible in the service provider's gross income.
    (ii) Adoptions of new arrangements. It is presumed that the 
adoption of a new arrangement or the grant of an additional benefit 
under an existing arrangement after October 3, 2004, and before January 
1, 2005, constitutes a material modification of a plan. However, the 
presumption may be rebutted by demonstrating that the adoption of the 
arrangement or grant of the additional benefit is consistent with the 
service recipient's historical compensation practices. For example, the 
presumption that the grant of a discounted stock option on November 1, 
2004, is a material modification of a plan may be rebutted by 
demonstrating that the grant was consistent with the historic practice 
of granting substantially similar discounted stock options (both as to 
terms and amounts) each November for a significant number of years. 
Notwithstanding paragraph (a)(4)(i) and this paragraph (a)(4)(ii), the 
grant of an additional benefit under an existing arrangement that 
consists of a deferral of additional compensation not otherwise 
provided under the plan as of October 3, 2004, will be treated as a 
material modification of the plan only as to the additional deferral of 
compensation, if the plan explicitly identifies the additional deferral 
of compensation and provides that the additional deferral of 
compensation is subject to section 409A. Accordingly, amendments to 
conform a plan to the requirements of section 409A with respect to 
deferrals under a plan occurring after December 31, 2004, will not 
constitute a material modification of the plan with respect to amounts 
deferred that are earned and vested on or before December 31, 2004, 
provided that there is no concurrent material modification with respect 
to the amount of, or rights to, amounts deferred that were earned and 
vested on or before December 31, 2004. Similarly, a grant of an 
additional benefit under a new arrangement adopted after October 3, 
2004, and before January 1, 2005, will not be treated as a material 
modification of an existing plan to the extent that the new arrangement 
explicitly identifies additional deferrals of compensation and provides 
that the additional deferrals of compensation are subject to section 
409A.
    (iii) Suspension or termination of a plan. A cessation of deferrals 
under, or termination of, a plan, pursuant to the provisions of such 
plan, is not a material modification. Amending an arrangement to stop 
future deferrals thereunder is not a material modification of the 
arrangement or the plan. Amending an arrangement to provide 
participants an election whether to terminate participation in a plan 
constitutes a material modification of the plan.
    (iv) Changes to investment measures--account balance plans. With 
respect to an account balance plan (as defined in Sec.  31.3121(v)(2)-
1(c)(1)(ii) of this chapter), it is not a material modification to 
change a notional investment measure to, or to add to existing 
investment measures, an investment measure that qualifies as a 
predetermined actual investment within the meaning of Sec.  
31.3121(v)(2)-1(d)(2) of this chapter or, for any given taxable year, 
reflects a reasonable rate of interest (determined in accordance with 
Sec.  31.3121(v)(2)-1(d)(2)(i)(C) of this chapter). For this purpose, 
if with respect to an amount deferred for a period, a plan provides for 
a fixed rate of interest to be credited, and the rate is to be reset 
under the plan at a specified future date that is not later than the 
end of the fifth calendar year that begins after the beginning of the 
period, the rate is reasonable at the beginning of the period, and the 
rate is not changed before the reset date, then the rate will be 
treated as reasonable in all future periods before the reset date.
    (v) Rescission of modifications. Any modification to the terms of a 
plan that would inadvertently result in treatment as a material 
modification under this section is not considered a material 
modification of the plan to the extent the modification in the terms of 
the plan is rescinded by the earlier of a date before the right is 
exercised (if the change grants a discretionary right) or the last day 
of the calendar year during which such change occurred. Thus, for 
example, if a service recipient modifies the terms of a plan on March 1 
to allow an election of a new change in the time or form of payment 
without realizing that such a change constituted a material 
modification that would subject the plan to the requirements of section 
409A, and the modification is rescinded on November 1, then if no 
change in the time or form of payment has been made pursuant to the

[[Page 57984]]

modification before November 1, the plan is not considered materially 
modified under this section.
    (vi) Definition of plan. For purposes of this paragraph (a)(4), the 
term plan has the same meaning provided in Sec.  1.409A-1(c), except 
that the provision treating all account balance plans under which 
compensation is deferred as a single plan, all nonaccount balance plans 
under which compensation is deferred as a separate single plan, all 
separation pay arrangements due to an actual involuntary separation 
from service or participation in a window program as a separate single 
plan, and all other nonqualified deferred compensation plans as a 
separate single plan, does not apply.
    (b) [Reserved].

Mark E. Matthews,
Deputy Commissioner of Services and Enforcement.
[FR Doc. 05-19379 Filed 9-29-05; 8:45 am]
BILLING CODE 4830-01-P