[Federal Register Volume 72, Number 73 (Tuesday, April 17, 2007)]
[Rules and Regulations]
[Pages 19234-19325]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 07-1820]



[[Page 19233]]

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

Part II





Department of the Treasury





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



Internal Revenue Service



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



26 CFR Part 1



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

  Federal Register / Vol. 72, No. 73 / Tuesday, April 17, 2007 / Rules 
and Regulations  

[[Page 19234]]


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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9321]
RIN 1545-BE79


Application of Section 409A to Nonqualified Deferred Compensation 
Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

SUMMARY: This document contains final regulations regarding the 
application of section 409A to nonqualified deferred compensation 
plans. The final regulations are necessary to clarify and explain the 
rules governing the application of section 409A to nonqualified 
deferred compensation plans. The regulations affect service providers 
receiving amounts of deferred compensation and the service recipients 
for whom the service providers provide services.

FOR FURTHER INFORMATION CONTACT: Stephen Tackney, (202) 927-9639 (not a 
toll-free number).

DATES: Effective Date: These regulations are effective April 17, 2007.
    Applicability Dates: For dates of applicability, see Sec.  1.409A-
6(b).

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 a nonqualified deferred compensation plan, 
where such arrangements are located outside of the United States or are 
restricted to the provision of benefits in connection with a decline in 
the financial health of the sponsor.
    On December 20, 2004, the IRS issued Notice 2005-1 (published as 
modified on January 6, 2005, in 2005-1 CB 274), setting forth initial 
guidance with respect to the application of section 409A, and supplying 
transition guidance pursuant to a statutory directive. A notice of 
proposed rulemaking (REG-158080-04, 2005-2 CB 786 [70 FR 57930]) was 
published in the Federal Register on October 4, 2005. See Sec.  
601.601(a)(3). A public hearing was conducted on January 25, 2006. In 
addition, the IRS received written and electronic comments responding 
to the notice of proposed rulemaking. After consideration of all the 
comments, the proposed regulations are adopted as amended by this 
Treasury decision. The amendments are discussed in this preamble.
    The Treasury Department and the IRS have also issued six additional 
notices providing transition guidance with respect to section 409A: (1) 
Notice 2005-94, 2005-2 CB 1208 (transition guidance with respect to 
2005 reporting and withholding obligations); (2) Notice 2006-4, 2006-3 
IRB 307 (transition guidance with respect to certain outstanding stock 
rights); (3) Notice 2006-33, 2006-15 IRB 754 (transition guidance with 
respect to the application of section 409A(b)); (4) Notice 2006-64, 
2006-29 IRB 88 (interim guidance regarding payments necessary to meet 
Federal conflict of interest requirements); (5) Notice 2006-79, 2006-43 
IRB 763 (additional transition relief); and (6) Notice 2006-100, 2006-
51 IRB 1109 (transition guidance with respect to 2005 and 2006 
reporting and withholding obligations). See Sec.  601.601(d)(2). For a 
discussion of the continued applicability of these notices, see the 
Effect on Other Documents section of this preamble.

Explanation of Provisions and Summary of Comments

I. Structure and Format of Regulations

    The final regulations generally adopt the structure and format of 
the proposed regulations. A table of contents has been included in the 
final regulations, as well as several additional sets of examples 
addressing various topics.

II. Definition of Nonqualified Deferred Compensation Plan

A. Excluded Plans
    The final regulations exclude the types of plans described in 
section 409A(d)(1) from the definition of a nonqualified deferred 
compensation plan, as well as certain other arrangements that were also 
set forth in the proposed regulations. Accordingly, the final 
regulations generally provide that a nonqualified deferred compensation 
plan for purposes of section 409A does not include a qualified plan, a 
bona fide sick leave or vacation plan, a disability plan, a death 
benefit plan, or certain medical expense reimbursement arrangements.
    The final regulations clarify that the exemption from coverage 
under section 409A for certain welfare plans does not apply to medical 
expense reimbursements that constitute taxable income to the service 
provider. The coverage exemption applies only to arrangements that 
provide benefits that are excludable from gross income under section 
105 or section 106.
    Several commentators requested clarification of when a leave 
program will be treated as a bona fide sick leave or vacation leave 
plan for purposes of section 409A. Another commentator requested a 
clarification of the definition of a compensatory time plan. Because 
the definitions of these terms may raise issues and require 
coordination with the provisions of section 451, section 125, and, with 
respect to certain taxpayers, section 457, the final regulations do not 
address these issues.
    Notice 2005-1, Q&A-6 provides that, until further guidance, 
taxpayers whose participation in a nonqualified deferred compensation 
plan would be subject to section 457(f) may rely on the definitions of 
bona fide vacation leave, sick leave, compensatory time, disability 
pay, or death benefit plan applicable for purposes of section 457(f) as 
also being applicable for purposes of section 409A. Until further 
guidance, such taxpayers may continue to rely on such definitions for 
purposes of section 409A.
    One commentator requested that a qualified employer plan for 
purposes of the exclusion from section 409A include certain plans 
covered by section 402(d) (certain plans with a foreign-situs trust 
treated as qualified plans with respect to the taxation of the 
participants and beneficiaries) and retirement plans described in 
section 1022(i)(2) of the Employee Retirement Income Security Act of 
1974, as amended (certain Puerto Rican retirement plans). The final 
regulations adopt this suggestion.
B. Section 457 Plans
    The final regulations provide that section 409A is not applicable 
to an eligible deferred compensation plan under section 457(b), but may 
be applicable to a deferred compensation plan that is subject to 
section 457(f). Commentators requested clarification of the application 
of the exception in the proposed regulations from the definition of 
deferred compensation referred to as the short-term deferral rule 
(described in section III.C.1 of this preamble) to a section 457(f) 
plan. As discussed below, a right to deferred compensation

[[Page 19235]]

generally refers to a legally binding right in one taxable year to 
compensation that is or may be payable in a subsequent taxable year. 
For purposes of determining the time of payment, the term ``payment'' 
generally refers to an actual or constructive payment of cash or 
property. However, the final regulations provide that for purposes of 
the short-term deferral rule, an amount is treated as paid when it is 
included in income under section 457(f) whether or not an actual or 
constructive payment occurs. Accordingly, where the income inclusion 
under section 457(f) stems from the lapse of a substantial risk of 
forfeiture that is also treated as a substantial risk of forfeiture for 
purposes of section 409A, the amount included in income will be 
considered a short-term deferral for purposes of section 409A. However, 
the right to earnings on amounts that have previously been included 
under section 457(f) will be deferred compensation for purposes of 
section 409A unless the right to the earnings independently satisfies 
the requirements for an exclusion.
C. Arrangements With Independent Contractors
    The final regulations provide that section 409A generally does not 
apply to an amount deferred under an arrangement between a service 
provider and an unrelated service recipient if during the service 
provider's taxable year in which the service provider obtains a legally 
binding right to the deferred amount the service provider is actively 
engaged in the trade or business of providing services (other than as 
an employee or as a director of a corporation), and provides 
significant services to two or more service recipients to which the 
service provider is not related and that are not related to one 
another.
    The final regulations retain the safe harbor in the proposed 
regulations, under which a service provider is deemed to be providing 
significant services to two or more such service recipients for this 
purpose if the revenues generated from the services provided to any 
service recipient or group of related service recipients during such 
taxable year do not exceed 70 percent of the total revenues generated 
by the service provider from the trade or business of providing such 
services. Commentators expressed concern that the safe harbor did not 
permit independent contractors to know in advance whether the 
arrangements under which an independent contractor deferred 
compensation during a taxable year would be subject to section 409A. 
Commentators requested certain look-back periods, including the ability 
to use averaging over the previous three to five years, or to satisfy 
the 70 percent threshold over a certain portion of the previous three 
to five years. The Treasury Department and the IRS are concerned that 
the suggested rules would allow service providers to engage in 
strategic behavior to ensure that activity in certain years would be 
exempt from section 409A. Accordingly, the final regulations adopt an 
additional safe harbor that provides that a service provider that has 
actually met the 70 percent threshold in the three immediately previous 
years is deemed to meet the 70 percent threshold for the current year, 
but only if at the time the amount is deferred the service provider 
does not know or have reason to anticipate that the service provider 
will fail to meet the threshold in the current year.
    In response to comments, the final regulations provide that if an 
independent contractor qualifies for the safe harbor for exclusion from 
coverage under section 409A with respect to arrangements with unrelated 
service recipients, an arrangement between the independent contractor 
and a service recipient related to the independent contractor will not 
be subject to section 409A if the arrangement, and the practices under 
the arrangement, are bona fide, arise in the ordinary course of 
business, and are substantially the same as the arrangements and 
practices (such as billing and collection practices) applicable to one 
or more unrelated service recipients to whom the independent contractor 
provides substantial services and that produce a majority of the total 
revenue that the independent contractor earns from the trade or 
business of providing such services during the year.
    The final regulations further clarify that if at the time the 
legally binding right to the payment arose, the arrangement was not 
subject to section 409A because the service provider was an independent 
contractor that was eligible for this exclusion from coverage under 
section 409A, the amount deferred under the arrangement during that 
taxable year (and earnings credited to the deferred amount) will not 
become subject to section 409A in a later year if the service provider 
becomes an employee, independent contractor, or other type of service 
provider subject to the rules of section 409A.
    Commentators also requested that a service recipient be permitted 
to rely upon a representation of an independent contractor that the 
independent contractor meets the exclusion requirements, so that a 
service recipient will know whether it is subject to the reporting 
requirements with respect to amounts deferred subject to section 409A. 
The Treasury Department and the IRS are continuing to study this issue.
D. Anti-Abuse Rule
    If a principal purpose of a plan is to achieve a result with 
respect to a deferral of compensation that is inconsistent with the 
purposes of section 409A, the Commissioner may treat the plan as a 
nonqualified deferred compensation plan for purposes of section 409A.

III. Definition of Nonqualified Deferred Compensation Plan

A. In General
    The final regulations provide that a nonqualified deferred 
compensation plan is a plan that provides for the deferral of 
compensation. The final regulations further provide that a plan 
generally provides for the deferral of compensation if, under its terms 
and the relevant facts and circumstances, a service provider has a 
legally binding right during a taxable year to compensation that, 
pursuant to its terms, is or may be payable to (or on behalf of) the 
service provider in a later year. For this purpose, an amount generally 
is payable at the time the service provider has a right to currently 
receive a transfer of cash or property, including a transfer of 
property includible in income under section 83, the economic benefit 
doctrine or section 402(b). Accordingly, a taxable transfer of an 
annuity contract is treated as a payment for purposes of section 409A.
    The definition of deferral of compensation in the final regulations 
excludes the condition that the amount not be actually or 
constructively received and included in income during the taxable year, 
because that language might cause confusion with respect to the 
applicable rules governing deferral elections and the prohibition on 
the acceleration of payments. For example, if a service provider has 
made an irrevocable election to defer an amount of his or her salary to 
a future year, that amount is treated as deferred compensation 
regardless of whether the service recipient actually pays such amount 
to the service provider during the year in which the services are 
performed. Any early payment of the deferred compensation (or any right 
to receive such an early payment) generally would constitute an 
impermissible acceleration of the payment of the deferred amount.

[[Page 19236]]

    For this purpose, a plan will be treated as providing for a payment 
to be made in a subsequent year whether the plan explicitly so provides 
(including through a service provider election) or the deferral 
condition is inherent in the terms of the contract. Where the parties 
have agreed that a payment will be made upon an event that could occur 
after the year in which the legally binding right to the payment 
arises, the plan generally will provide for a deferral of compensation 
(unless otherwise excluded under a specific exception, such as the 
short-term deferral rule).
    For example, if a plan provides a service provider a right to a 
payment upon separation from service, the plan generally will result in 
a deferral of compensation regardless of whether the service provider 
separates from service and receives the payment in the same year as the 
grant, because under the plan the payment is conditioned upon an event 
that may occur after the year in which the legally binding right to the 
payment arises. Similarly, if an arrangement such as a stock option or 
stock appreciation right not otherwise excluded from coverage under 
section 409A provides a right to a payment for a term of years where 
the payment could be received during the short-term deferral period or 
a subsequent period but is not otherwise includible in income until 
paid, the arrangement will provide for deferred compensation even 
though the service provider could receive the payment during the short-
term deferral period (for example, by exercising the stock option or 
stock appreciation right). However, where a plan does not specify a 
payment date, payment event or term of years (or specifies a date or 
event certain to occur during the year in which the services are 
performed), the plan generally will not provide for the deferral of 
compensation if the service provider actually or constructively 
receives the payment within the short-term deferral period.
    The proposed regulations provided that earnings on deferred amounts 
are generally treated as deferred compensation for purposes of section 
409A. Under the final regulations, whether a deferred amount 
constitutes earnings on an amount deferred, or actual or notional 
income attributable to an amount deferred, is determined under the 
principles defining income attributable to the amount taken into 
account under Sec.  31.3121(v)(2)-1(d)(2).
    A commentator requested clarification of whether a payment for a 
noncompetition agreement could be subject to section 409A. Because such 
a payment would occur in connection with the performance or 
nonperformance of services, and a covenant not to compete does not 
create a substantial risk of forfeiture for purposes of section 409A, a 
legally binding right obtained in one year to a payment in a subsequent 
year in connection with a noncompetition agreement generally would 
constitute deferred compensation.
B. Legally Binding Right
    The regulations define deferral of compensation in the context of a 
legally binding right to a payment of compensation in a future taxable 
year. Commentators requested clarification of the standard that would 
be used to determine whether a service provider has a legally binding 
right. A legally binding right includes a contractual right that is 
enforceable under the applicable law or laws governing the contract. A 
legally binding right also includes an enforceable right created under 
other applicable law, such as a statute.
    One commentator suggested that no legally binding right exists 
where the payment is made only upon the realization of gain from a 
particular investment. For example, the commentator argued that a bonus 
payable based upon the amount that a service provider obtains in 
selling property should not be treated as granting the service provider 
a legally binding right to the payment until the property is sold. In 
such a situation, however, the requirement that the property be sold is 
a condition to the right to the payment, but the right to the payment 
is still a legally binding right. The service recipient could not 
simply revoke the promise, sell the property, and not pay the bonus. 
However, the condition that the property be sold before the service 
provider becomes entitled to payment may constitute a substantial risk 
of forfeiture, depending on the specific facts and circumstances.
C. Short-Term Deferrals
1. In General
    Subject to the modifications described in this section III.C of the 
preamble, the final regulations generally adopt the short-term deferral 
rule that was contained in the proposed regulations. Under the short-
term deferral rule, a deferral of compensation does not occur for 
purposes of section 409A if the arrangement under which a payment is 
made does not provide for a deferred payment and the payment is made no 
later than the 15th day of the third month following the later of the 
end of the service provider's taxable year or the end of the service 
recipient's taxable year in which occurs the later of the time the 
legally binding right to the payment arises or the time such right 
first ceases to be subject to a substantial risk of forfeiture (subject 
to certain extensions for unforeseeable events). For this purpose, an 
arrangement provides for a deferred payment if it provides for a 
payment that will be made or completed after a date or an event that 
will or may occur later than the end of the 2\1/2\ month period 
described in the preceding sentence, either because of an affirmative 
election on the part of the service provider or service recipient or a 
deferral condition inherent in the terms of the contract (for example, 
that the amount will be paid upon the service provider's separation 
from service, which may occur in a future year).
    Several commentators requested that additional flexibility be 
provided to allow payments to be short-term deferrals. By analogy to 
the rules in the proposed regulations concerning when payments of 
deferred compensation amounts are considered timely for purposes of the 
payment date rules, the commentators suggested that payments should 
qualify as short-term deferrals if made by the end of the year after 
the year in which a substantial risk of forfeiture lapses, rather than 
by the 15th day of the third month of that year. The final regulations 
do not adopt this suggestion. The short-term deferral rule is based on 
the historical treatment of certain payments paid within a short period 
following the end of a taxable year as not constituting deferred 
compensation. See Sec.  1.404(b)-1T, Q&A-2(b). That short period has 
been defined as ending on the 15th day of the third month following the 
end of the year, subject to certain extensions for unforeseeable 
events. Extending the payment date by which a short-term deferral could 
be paid would be inconsistent with this approach and the legislative 
history of section 409A (H.R. Conf. Rep. No. 108-755, at 735 (2004)), 
and accordingly is not adopted in the final regulations. However, the 
final regulations liberalize the standard under which a payment can be 
a short-term deferral even if it is delayed due to unforeseeable 
events. The proposed regulations provided generally that payment could 
be delayed if the payment would jeopardize the service recipient's 
solvency and such insolvency was unforeseeable at the time the service 
provider obtained the right to the payment. By contrast, the final 
regulations provide generally that payment may be delayed where the

[[Page 19237]]

payment would jeopardize the ability of the service recipient to 
continue as a going concern.
    Commentators asked how the short-term deferral rule applies to a 
series of payments scheduled to commence following the lapse of a 
substantial risk of forfeiture. The final regulations provide that the 
short-term deferral rule applies separately to each payment, applying 
the technical definition of ``payment'' set out in the regulations, 
provided that the entire payment is made during the short-term deferral 
period. Accordingly, where a payment has been designated as a separate 
payment, it may qualify as a short-term deferral (and thus not deferred 
compensation) even where the service provider has a right to subsequent 
payments under the same arrangement. In contrast, where a payment has 
not been designated as a separate payment (such as, for example, a life 
annuity payment or a series of installment payments treated as a single 
payment), any initial payments in the series will not be treated as a 
short-term deferral even if paid within the short-term deferral period. 
For a discussion of the definition of payment, see Sec.  1.409A-3.
    Commentators suggested that a right to a reimbursement be treated 
as potentially subject to the short-term deferral rule, arguing that 
the right to the reimbursement payment is subject to a substantial risk 
of forfeiture that the service provider will not incur the expense. 
Commentators argued that the short-term deferral rule then could apply 
if the reimbursement payment were made within a short period following 
the occurrence of the expense. Generally, the risk that a service 
provider will fail to incur a reimbursable expense will not qualify as 
a substantial risk of forfeiture, so the short-term deferral rule will 
not be applicable. However, the final regulations provide considerable 
additional flexibility with regard to structuring reimbursement 
arrangements to meet the requirements of section 409A. For a discussion 
of these provisions, see section VII.B.2 of this preamble.
2. Application to Event-Based Payments
    Some commentators asked whether any payments based on a legally 
binding right arising in the year of a separation from service are 
excluded from coverage under section 409A, if paid by the end of the 
relevant short-term deferral period. For example, where an employee had 
accrued benefits under a defined benefit supplemental executive 
retirement plan (SERP) during his career that was payable immediately 
upon a separation from service, including an amount accrued in the year 
of separation from service, commentators asked whether the payment of 
the portion of the benefits accrued in that final year is excluded from 
coverage under section 409A if paid by March 15 of the year following 
the separation from service, because the amount is paid within a short 
period following the year the service provider obtains a vested legally 
binding right to the additional benefit accrual. (This generally would 
be of most concern to specified employees subject to the requirement of 
a six-month delay in payment following a separation from service.)
    The analysis that applies in this situation is similar to that 
applied to the general definition of deferral of compensation, 
discussed in section III.A of this preamble. The short-term deferral 
rule does not provide an exclusion from the requirements of section 
409A for such current-year benefit accruals because the rule does not 
apply to amounts of compensation subject to a deferral election. For 
this purpose, an election to defer includes either an affirmative 
election on the part of the service provider or a deferral condition 
inherent in the terms of the contract. Where the parties have agreed 
that a payment will be made upon an event that does not necessarily 
coincide with the lapsing of the substantial risk of forfeiture, and 
could occur at a time beyond the short-term deferral period, the 
arrangement provides for a deferral election such that the short-term 
deferral rule does not apply. Accordingly, in this example, because the 
benefits accrued in the final year of the SERP could have been paid 
upon an event occurring after the short-term deferral period (if, for 
example, the individual had not separated from service until a later 
year), the payment of the benefit accrued in the final year is subject 
to section 409A and is not a short-term deferral, even if paid by March 
15 of the year following the separation from service.
    Also, for example, if a plan that is not subject to section 457(f) 
provides that an amount is subject to a substantial risk of forfeiture 
until the completion of three years of service, and is payable upon a 
separation of service following the three years of service, the right 
to the amount is not a short-term deferral even if the service provider 
separates from service immediately after vesting in the right, because 
under the plan the payment is based upon an event other than the 
lapsing of the substantial risk of forfeiture and such event may occur 
in a year subsequent to the year in which the risk of forfeiture 
lapses.
    Conversely, where a plan specifies no payment date or payment 
event, or specifies only the date at which the substantial risk of 
forfeiture lapses, the plan may qualify for the short-term deferral 
rule if the payment is made within the applicable short-term deferral 
period. However, such a plan generally would violate section 409A if 
the payment were made after the short-term deferral period.
    As discussed in this preamble with respect to the general 
definition of deferred compensation, to implement the statutory scheme, 
including the applicable reporting and form requirements, taxpayers 
generally must be able to determine whether an arrangement provides for 
a deferral of compensation at the time the service provider obtains a 
legally binding right to the compensation. Although a plan need not 
specify a payment date to be a short-term deferral that is excluded 
from coverage under section 409A, the short-term deferral exclusion 
does not apply if the payment event or date is specified and will or 
may occur after the end of the short-term deferral period.
    The preamble to the proposed regulations explained that where a 
plan requires that a payment be made on a date within the short-term 
deferral period, but the payment is made after the specified date and 
after the end of the short-term deferral period, the arrangement will 
be treated as a nonqualified deferred compensation plan, but the 
payment date will be treated as a specified date. Thus, under such an 
arrangement, if the service provider receives the payment after the 
specified date, but not later than the end of the year in which the 
specified date occurs, the payment generally will comply with section 
409A. However, taxpayers should note that a provision requiring only 
that a payment be made on or before the end of the short-term deferral 
period may not qualify as a permissible specified date for this 
purpose, if under the facts and circumstances the payment could have 
been made in more than one taxable year. For a discussion of the 
application of the definition of a specified payment date to this type 
of plan, see section VII.B of this preamble.
    For a discussion of when rights to compensation upon a separation 
from service for good reason may be treated as rights to compensation 
upon an involuntary termination, and the potential application of the 
short-term deferral exception to these arrangements, see section 
III.J.3 of this preamble.

[[Page 19238]]

D. Stock Options and Stock Appreciation Rights
1. In General
    Subject to the modifications described in this preamble, the final 
regulations adopt the provisions of the proposed regulations excluding 
from coverage under section 409A statutory stock options and certain 
other stock rights. Generally under the regulations, nondiscounted 
stock options and nondiscounted stock appreciation rights issued on 
service recipient stock that do not include any additional deferral 
feature are excluded from section 409A.
2. Statutory Stock Options
    The final regulations adopt the exclusion from coverage under 
section 409A for statutory stock options, including incentive stock 
options described in section 422 of the Code and options granted under 
an employee stock purchase plan described in section 423 of the Code. 
This exclusion applies regardless of whether the statutory stock option 
would be excluded if the same option were not treated as a statutory 
stock option. For example, an employee stock purchase plan described in 
section 423 offering a discounted purchase price is not a deferred 
compensation plan for purposes of section 409A.
    Commentators requested clarification, however, of the treatment of 
a statutory stock option that is modified, or otherwise becomes 
ineligible to be treated as a statutory stock option. The final 
regulations adopt the rule set forth in the proposed regulations, and 
provide that at the time of such modification or event, the 
modification or other event is treated as the grant of a new option, or 
causes the option to be treated as having had a deferral feature from 
the date of grant, as applicable, for purposes of section 409A only if 
such modification or other event would have been so treated had the 
option been a nonstatutory stock option immediately before such 
modification or other event. For example, where an incentive stock 
option is modified through an extension of the option's term, the 
extended option will be treated as having had an additional deferral 
feature from the date of grant for section 409A purposes only if the 
same extension of a nonstatutory stock option would have resulted in 
such treatment.
    Commentators also requested that the exclusion from coverage under 
section 409A for certain stock rights issued under plans meeting the 
requirements of section 423 (employee stock purchase plans) be extended 
to employee stock purchase plans offered by foreign employers that do 
not meet such requirements, where the shares are made available for 
purchase at a discount and substantially all of the participants are 
nonresident aliens. The legislative history does not provide a basis 
for extending the exception applicable to options meeting the 
requirements of section 423 to grants of discounted stock options not 
meeting the requirements of section 423. Accordingly, this suggestion 
is not adopted in the final regulations.
3. Definition of Service Recipient Stock
    The final regulations adopt the requirement in the proposed 
regulations that for the exclusion for certain stock rights to apply, 
the stock right must relate to service recipient stock. Commentators 
criticized the definition of service recipient stock contained in the 
proposed regulations as too restrictive. Generally such criticisms 
centered on two different aspects of the definition of service 
recipient stock in the proposed regulations--the classes of stock that 
may qualify as service recipient stock, and the issuer or issuers whose 
stock may constitute service recipient stock, where the service 
recipient is comprised of more than one entity.
a. Classes of Stock That May Qualify as Service Recipient Stock
    Commentators requested clarification and expansion of the classes 
of stock of a corporation that may constitute service recipient stock. 
Commentators generally focused on two issues. First, with respect to 
stock of a particular service recipient corporation, commentators 
requested that the stock right be permitted to relate to any class of 
common stock, regardless of whether another class of common stock of 
that corporation was publicly traded, and regardless of whether that 
class of common stock had the greatest aggregate value of all classes 
of common stock issued by that corporate entity. Subject to the 
restrictions governing certain preferences as to distributions, the 
final regulations generally provide that any class of common stock may 
be used, regardless of whether another class of common stock that could 
qualify as service recipient stock is publicly traded or has a higher 
aggregate value outstanding, and regardless of whether the class of 
stock is subject to transferability restrictions or buyback rights 
(provided such buyback rights reflect the fair market value of the 
stock at the time of purchase).
    Second, commentators suggested narrowing the types of preferences 
on a class of common stock that would prohibit that class from being 
treated as service recipient stock. One commentator requested that the 
classes of stock permitted as service recipient stock include any class 
of stock that is widely held by non-service recipients. While it may be 
unlikely that a widely-held class of stock was created to facilitate an 
abusive avoidance of section 409A, it does not follow that service 
recipient stock rights issued on such stock necessarily would be 
consistent with the intended application of section 409A if, for 
example, holders of such class enjoyed preferences that would make such 
stock rights a suitable substitute for nonqualified deferred 
compensation.
    To be treated as service recipient stock under the final 
regulations, a class of stock must qualify as common stock under 
section 305 of the Code. Accordingly, the final regulations provide 
that stock that is not common stock under section 305 is not service 
recipient stock for purposes of section 409A. However, the mere 
classification of a class of stock as common stock under section 305 is 
not sufficient for such stock to be treated as service recipient stock 
for purposes of section 409A. The Treasury Department and the IRS are 
concerned that classes of stock that are common stock under section 305 
may provide preferences that could permit stock rights with respect to 
such stock to resemble traditional nonqualified deferred compensation, 
such that exclusion of such stock rights would permit the avoidance of 
section 409A.
    Commentators suggested that a preference with respect to 
liquidation rights, without any other preferences such as a 
preferential right to dividends, should be permitted under the 
definition of service recipient stock. A holder of this class of stock 
would not be guaranteed any return, but rather would simply be 
guaranteed preferred distribution rights upon a complete liquidation of 
the service recipient. The final regulations generally adopt this 
suggestion.
    With respect to other preferential rights, commentators were unable 
to provide a workable standard under which permissible preferences 
could be distinguished from impermissible preferences. Accordingly, the 
final regulations do not treat any stock including such preferences as 
service recipient stock. However, the Treasury Department and the IRS 
continue to study this area, and the final regulations authorize the 
publication of other additional guidance, should a workable standard be 
developed.

[[Page 19239]]

b. Entities the Stock of Which May Qualify as Service Recipient Stock
    Commentators also requested an expansion of the class of entities 
the stock of which can qualify as service recipient stock where the 
service recipient is comprised of multiple entities. The Treasury 
Department and the IRS believe that the stock right exception under 
section 409A was intended to cover stock rights directly reflecting the 
enterprise value of the entity for which the service provider is 
providing services. Consistent with this approach, the final 
regulations provide that service recipient stock may include the stock 
of the corporation for which the service provider was providing 
services at the date of grant. In addition, the final regulations 
provide that service recipient stock may include stock of any 
corporation in a chain of organizations all of which have a controlling 
interest in another organization, beginning with the parent 
organization and ending with the organization for which the service 
provider was providing services at the date of grant of the stock 
right. Similarly to the proposed regulations, the final regulations 
provide that the term ``controlling interest'' has the same meaning as 
provided in Sec.  1.414(c)-2(b)(2)(i), except that where that 
regulation requires at least an 80 percent interest, the final 
regulations generally require only a 50 percent interest. In addition, 
where the use of such stock with respect to the grant of a stock right 
to such service provider is based upon legitimate business criteria, 
the final regulations generally require only a 20 percent interest. For 
purposes of determining ownership of an interest in an organization, 
the attribution rules of Sec.  1.414(c)-4 apply, and the exclusion 
rules of Sec.  1.414(c)-3 also apply. For example, under the final 
regulations, with respect to an employee of a subsidiary corporation, 
the common stock of the ultimate parent corporation, or of a subsidiary 
corporation anywhere in the chain of corporate ownership between the 
subsidiary that employed the employee and the ultimate parent 
corporation (a higher tier subsidiary), could qualify as service 
recipient stock for purposes of determining whether a stock right 
issued to such employee with respect to such stock was excluded from 
coverage under section 409A, provided that the 50 percent or 20 percent 
ownership standard, as applicable, was satisfied by each corporation in 
the chain.
    The proposed regulations contained many requirements for using an 
ownership level of less than 50 percent. Commentators requested several 
simplifications of these requirements. In response, the final 
regulations no longer require a formal election by any corporation. 
Rather, each individual grant of a stock right is analyzed to determine 
whether the stock qualifies as service recipient stock with respect to 
a service provider at the time the stock right is granted. If a 
corporation owns at least 50 percent of the stock of one corporation 
and owns less than 50 percent of the stock of another corporation, and 
it intends to treat its stock as service recipient stock with respect 
to employees of both corporations, there is no requirement that a 
legitimate business criteria exist with respect to the issuance of 
stock rights on the parent corporation stock to service providers of 
the first such corporation. The legitimate business criteria standard 
applies only to stock rights issued to service providers of 
subsidiaries that are not majority-owned, because the test of 
legitimate business criteria relates to the actual issuance of a stock 
right to a particular service provider. Accordingly, a subsidiary may 
have more than one shareholder corporation the stock of which qualifies 
as service recipient stock with respect to a subsidiary employee such 
as, for example, where three entities each own a one-third interest in 
the subsidiary. However, with respect to each grant of a stock right on 
stock of a particular non-majority shareholder corporation to a service 
provider of a particular subsidiary, there must exist legitimate 
business criteria for issuing such a stock right. Even if legitimate 
business criteria exist with respect to the issuance of a stock right 
on stock of a particular shareholder corporation to a particular 
service provider, legitimate business criteria may or may not exist 
with respect to the issuance of a stock right to the same service 
provider on stock of another shareholder corporation.
    The legitimate business criteria requirement is a facts and 
circumstances test, focusing generally on whether there is sufficient 
nexus between a particular service provider and the entity, the stock 
of which underlies the stock right granted to the service provider, for 
the grant to serve a legitimate non-tax business purpose. As provided 
in the preamble to the proposed regulations, if a corporation issued a 
stock right on its stock to a current employee of a joint venture in 
which the corporation was a venturer, and the employee was a former 
employee of the corporate venturer, generally the issuance would be 
based on legitimate business criteria. Similarly, if the corporate 
venturer issued such a right to an employee of the joint venture who it 
reasonably expected would become an employee of the corporate venturer 
in the future, generally the legitimate business criteria requirement 
would be met. By contrast, where an employee has no real nexus with a 
corporate venturer, such as generally happens when the corporate 
venturer is a passive investor in the service recipient, the use of the 
investor corporation stock as the stock underlying a stock right grant 
to that employee generally would not be based upon legitimate business 
criteria. Similarly, where a corporation holds only a minority interest 
in an entity that in turn holds a minority interest in the entity for 
which the employee performs services, such that the corporation holds 
only an insubstantial indirect interest in the entity receiving the 
services, legitimate business criteria generally would not exist for 
issuing a stock right on the corporation's stock to the employee.
    The Treasury Department and the IRS remain concerned that the 
manipulation of the structure of a related group of corporations may be 
used to allow stock options or stock appreciation rights to mimic the 
characteristics of nonqualified deferred compensation, by compensating 
holders based on predictable amounts and investment returns unrelated 
to the enterprise value of an operating entity. Accordingly, the 
exception contained in the proposed regulations under which the stock 
of a corporation serving as investment vehicle is not considered 
service recipient stock has been retained. In addition, an anti-abuse 
rule has been added to address corporate structures, transactions, or 
stock right grants, a principal purpose of which is the avoidance of 
the application of section 409A to an arrangement otherwise providing 
deferred compensation. These corporate structures, transactions, and 
stock right grants generally will occur where the structure, 
transaction, or grant is intended to provide enhanced security for the 
value of the stock right as a means of providing deferred compensation, 
rather than as compensation related to an increase in the true 
enterprise value of the service recipient. The regulations provide that 
if an entity becomes a member of a group of corporations or other 
entities treated as a single service recipient, and the primary source 
of income or value of such entity arises from the provision of 
management services to other members of the service recipient group, if 
any stock rights are issued with respect to such entity it is presumed 
that such

[[Page 19240]]

structure was established for purposes of avoiding the application of 
section 409A.
c. Equity Interests in Certain Non-Corporate Entities
    The final regulations permit certain equity interests in a non-
stock mutual company to be treated analogously to equity interests in a 
corporation. Commentators requested that the definition of service 
recipient stock be expanded to cover interests in cooperatives and 
interests in the value of an Indian tribal enterprise. The regulations 
do not include such interests in the definition of service recipient 
stock, but provide the IRS authority to provide guidance expanding the 
definition of service recipient stock. For a discussion of the 
application of the exclusion for certain stock rights to rights issued 
on equity interests in entities taxed as partnerships, see section 
III.G of this preamble.
4. Valuation
a. In General
    The final regulations provide that for the exclusion for stock 
rights to apply, the stock right must specify an exercise price of the 
stock right that may never be less than the fair market value of the 
underlying stock on the date the stock right is granted. For purposes 
of this discussion and the final regulations, the exercise price of a 
stock appreciation right refers to the base stock value from which the 
appreciation is measured for purposes of determining the compensation 
payable under the stock appreciation right (for example, a stock 
appreciation right providing for a payment of the excess of the fair 
market value of 100 shares over $100 would have a $1 per share exercise 
price).
    Several commentators expressed concerns regarding the determination 
of the fair market value of the underlying stock. Some commentators 
requested that the valuation rules applicable to incentive stock 
options be applied for purposes of the exclusion from section 409A. 
Under those rules, if the stock option would otherwise fail to be an 
incentive stock option solely because the exercise price was less than 
the fair market value of the underlying stock as of the date of grant, 
generally the option is treated as an incentive stock option if the 
issuer attempted in good faith to set the exercise price at fair market 
value. See section 422(c)(1). The Treasury Department and the IRS 
believe that this is not the appropriate standard for determining 
whether stock rights are subject to section 409A. Incentive stock 
options are subject to strict limitations on the amount of such options 
that may be granted to a particular employee. See section 422(d). In 
contrast, there are no such limits applicable to nonstatutory stock 
options, and grants of nonstatutory stock options often far exceed the 
limitation applicable to incentive stock options. In addition, section 
422(c)(1) explicitly provides for the good faith standard with respect 
to incentive stock options, while no such provisions exist within 
section 409A or its legislative history.
    Commentators requested clarification of the consistency standard 
with respect to the use of a valuation method. Specifically, 
commentators asked whether one valuation method could be used for 
purposes of establishing the exercise price while another method could 
be used for purposes of determining the fair market value of the stock 
at the time of the payment (for example, to determine the amount of 
payment in the case of a stock appreciation right or a stock option 
where the stock is subject to repurchase by the service recipient). The 
final regulations clarify that consistency is not required, provided 
that each valuation method used otherwise meets the requirements of the 
final regulations. Accordingly, a service recipient may use one 
valuation method for purposes of establishing an exercise price, but 
another valuation method for purposes of establishing the payment 
amount (in the case of a stock appreciation right) or the buyback 
amount (in the case of a stock option where the underlying stock is 
subject to a buyback arrangement). However, once an exercise price has 
been established, the exercise price may not be changed through the 
retroactive use of another valuation method. In addition, where after 
the date of grant, but before the date of exercise, of the stock right, 
the service recipient stock to which the stock right relates becomes 
readily tradable on an established securities market, the service 
recipient must use a valuation method for stock readily tradable on an 
established securities market for purposes of determining the payment 
amount (in the case of a stock appreciation right) or the buyback 
amount (in the case of a stock option where the underlying stock is 
subject to a buyback arrangement).
b. Valuation--Stock Readily Tradable on an Established Securities 
Market
    The final regulations adopt the rules under the proposed 
regulations governing valuation of stock readily tradable on an 
established securities market, generally requiring that the valuation 
of such stock be based upon the contemporaneous prices established in 
the securities market, subject to the modifications discussed in this 
preamble. Some commentators requested additional guidance with respect 
to when a stock will be treated as readily tradable. The final 
regulations adopt the same standard as that set forth in Sec.  1.280G-
1, Q&A-6(e), that stock is treated as readily tradable if it is 
regularly quoted by brokers or dealers making a market in such stock.
    With respect to the rules governing the valuation of stock that is 
readily tradable on an established securities market, commentators 
generally focused on the provision of the proposed regulations 
permitting the use of an average selling price during a specified 
period that is within 30 days before or 30 days after the date of 
grant. Specifically, comments concentrated on the requirement that the 
commitment to grant the stock right with an exercise price set using 
such an average selling price be irrevocable before the beginning of 
the specified period. Commentators questioned both the purpose of the 
requirement of the commitment to the valuation method, as well as the 
actions required to satisfy the rule if averaging were being used.
    The rule was intended to prohibit the use of an average price, set 
on a look-back basis, to ensure a discounted exercise price. For 
example, if a corporation decided to grant a stock option on July 1, 
and it could set the exercise price using an average selling price for 
any period falling within the prior 30 days without having had a prior 
commitment to a specific averaging period, the corporation could simply 
look for the lowest price that occurred during the prior June. 
Furthermore, if the corporation were not committed to grant the stock 
option on July 1, the corporation could wait until its stock price 
began to rise and then grant an option using the selling price on a 
given day during the previous 30 days to provide a particular discount. 
Accordingly, the final regulations require that the commitment to grant 
the stock right with an exercise price set using such an average 
selling price be irrevocable before the beginning of the specified 
period. To satisfy this requirement, the service recipient must 
designate the recipient of the stock option, the number of shares the 
stock option will permit the holder of the stock option to purchase, 
and the method for determining the exercise price including the period 
over which the averaging will occur, before the beginning of the 
specified averaging period.

[[Page 19241]]

    One commentator stated that the requirement of an irrevocable 
commitment to the averaging period could not be met under French law, 
because French law requires that the stock option exercise price be set 
based on the average trading price over the preceding 20 days and the 
commitment to the grant before the beginning of the period may be 
viewed as violating that requirement. The final regulations provide 
that where applicable foreign law requires that the compensatory stock 
right granted by the issuer must be priced based upon a specific price 
averaging method and period, a stock right granted in accordance with 
such applicable foreign law will be treated as meeting the requirement, 
provided that the averaging period may not exceed 30 days.
c. Valuation--Stock Not Readily Tradable on an Established Securities 
Market
i. In General
    The final regulations adopt the provisions in the proposed 
regulations relating to the valuation of stock not readily tradable on 
an established securities market, subject to the modifications 
discussed in this section III.C.4.c. Accordingly, a valuation of stock 
based upon a reasonable application of a reasonable valuation method is 
treated as reflecting the fair market value of the stock. To meet this 
standard, it is not necessary that a taxpayer demonstrate that the 
value was determined by an independent appraiser. Where the taxpayer 
can otherwise demonstrate that the valuation was determined by the 
reasonable application of a reasonable valuation method, the standard 
will be met.
    One commentator requested that the factors to be considered in 
determining the fair market value of the stock should be modified to 
include consideration of any recent equity sales made by the 
corporation in arm's-length transactions. The final regulations adopt 
this suggestion.
    The final regulations continue to require that in the case of a 
stock right issued with respect to stock that was not publicly traded 
at the time the right was issued, but becomes publicly traded before 
the right is exercised, the stock value for purposes of calculating the 
payment amount (in the case of a stock appreciation right) or the 
buyback amount (in the case of a stock option where the underlying 
stock is subject to a buyback agreement) must be based upon the rules 
governing stock that is publicly traded. This does not mean that the 
initial exercise price determined under the rules governing stock that 
is not publicly traded must be reset. Rather, this means only that the 
value at the time of exercise used to determine the payment amount or 
the buyback amount must be determined under the rules governing stock 
that is publicly traded. For example, if a service provider holds an 
excluded stock appreciation right with an exercise price of $1 that was 
fixed based on a valuation of the closely-held corporate stock at the 
time of grant, and before exercise the stock becomes readily tradable 
on an established securities market, the amount payable upon exercise 
must be the excess of the value of the stock based on its trading price 
over the $1 exercise price.
ii. Safe Harbor Presumptions
    The final regulations adopt a presumption in specified 
circumstances that, for purposes of section 409A, a valuation of stock 
reflects the fair market value of the stock, rebuttable only by a 
showing that the valuation is grossly unreasonable. The presumption 
applies where the valuation is based upon an independent appraisal, a 
generally applicable repurchase formula (applicable for both 
compensatory and noncompensatory purposes) that would be treated as 
fair market value under section 83, or, in the case of illiquid stock 
of a start-up corporation, a valuation by a qualified individual or 
individuals applied at a time that the corporation did not otherwise 
anticipate a change in control event or public offering of the stock.
    Many of the comments with respect to these presumptions related to 
the presumption applicable to illiquid stock of start-up corporations. 
As set forth in the proposed regulations, the start-up corporation 
presumption would not apply if the service recipient or service 
provider could reasonably anticipate, as of the time the valuation is 
applied, that the service recipient would undergo a change in control 
event or make a public offering of securities within the 12 months 
following the event to which the valuation is applied. Commentators 
suggested that a 12-month period is too long, because changes occur so 
rapidly in the business world that it often is difficult or impossible 
to predict so far in advance whether such an event will occur. 
Commentators suggested that the service provider should retain the 
benefit of the presumption unless the issuing corporation entered into 
a definitive agreement or filed its registration statement with the 
Securities and Exchange Commission within a period of 15 or 30 days 
after issuing the stock right.
    The Treasury Department and the IRS believe that a 15-day or a 30-
day period is too short. Although there is always a risk that a public 
offering will fail or that a corporate transaction will not occur, the 
Treasury Department and the IRS also believe that a person should 
reasonably be able to anticipate whether such a transaction will occur 
during a reasonable period before the transaction.
    Accordingly, the final regulations provide that the start-up 
corporation presumption will not apply if at the time the valuation is 
made, the service recipient or service provider may reasonably 
anticipate that the service recipient will undergo a change in control 
event in the next 90 days or an initial public offering within the next 
180 days. As under the proposed regulations, the rule in the final 
regulations is concerned with what the parties may reasonably 
anticipate at the time the stock right is issued.
    Other comments requested examples of persons with sufficient 
knowledge, experience, and skill in valuing illiquid stock of a start-
up corporation. Because knowledge, skill, and training may be obtained 
in different ways, the final regulations do not provide specific 
examples. However, the regulations clarify that the standard to be 
applied is whether a reasonable individual, upon being apprised of such 
person's relevant knowledge, experience, education, and training, would 
reasonably rely on the advice of such person with respect to valuation 
in deciding whether to accept an offer to purchase or sell the stock 
being valued. The final regulations also clarify that significant 
experience generally means at least five years of relevant experience 
in business valuation or appraisal, financial accounting, investment 
banking, private equity, secured lending, or other comparable 
experience in the line of business or industry in which the service 
recipient operates.
    With respect to the presumption based upon a generally applicable 
buyback formula, some commentators requested that the presumption apply 
where the formula is applicable to all compensatory stock transactions, 
but not also applicable to all noncompensatory stock transactions. The 
final regulations do not adopt this suggestion. However, the final 
regulations clarify that to meet the requirements of the presumption, 
the buyback formula is required to be applicable to compensatory and 
noncompensatory transactions with the issuer or a person owning 10 
percent or more of the stock of the issuer, but is not

[[Page 19242]]

required to be applicable to transactions with other persons or 
transactions that are part of an arm's length transaction constituting 
the sale of all or substantially all of the stock of the issuer to an 
unrelated purchaser.
5. Modification of a Stock Right
    The final regulations continue to apply certain rules addressing 
modifications, extensions and renewals of stock rights. Although these 
rules in many respects resemble the rules applicable to statutory stock 
options, the rules are not intended to incorporate the rules applicable 
to statutory stock options except where explicitly provided.
    The final regulations generally retain the rules in the proposed 
regulations that generally treat extensions of the exercise period of a 
stock right as an additional deferral feature as of the date of grant 
of the right, with an exception for certain limited extensions 
following a separation from service. Commentators characterized these 
rules as unnecessarily restrictive. Specifically, commentators argued 
that the extension of a stock option upon the occurrence of a 
separation from service (often in connection with a program of layoffs) 
or a corporate transaction is a common practice, and that often these 
extensions cover periods longer than the limited period provided in the 
proposed regulations. In addition, commentators argued that the same 
substantive results could be obtained by specifying a longer term for 
the stock right and providing the service recipient the discretion to 
shorten the term, rather than providing discretion to extend a shorter 
term, and that the former approach would be permissible under the 
proposed regulations. In response, the final regulations provide that 
the extension of an option exercise period generally is not treated as 
an additional deferral feature or a modification of the stock option 
for section 409A purposes if the exercise period is not extended beyond 
the earlier of the original maximum term of the option or 10 years from 
the original date of grant of the stock right.
    Many commentators also requested that the extension of the exercise 
period of a stock right not be treated as an additional deferral 
feature for purposes of section 409A, where at the time of the 
extension the fair market value of the underlying stock does not exceed 
the exercise price (an ``underwater'' option). Because the issuance of 
an otherwise identical option with an exercise period ending after the 
end of the exercise period of the underwater option would be excluded 
from coverage under section 409A, the final regulations provide that 
such an extension does not constitute an additional deferral feature.
    The final regulations adopt the provisions in the proposed 
regulations regarding substitution or assumption of stock rights due to 
a corporate transaction, which are generally in accordance with the 
corresponding provisions governing incentive stock options. The final 
regulations clarify that the applicable corporate transactions for this 
purpose include only those transactions described in Sec.  1.424-
1(a)(3). One commentator requested that the provision permitting 
substitutions of stock options be modified to reflect that a holder of 
a nonstatutory stock option is not required to be employed by the 
successor entity. The final regulations adopt this suggestion, so that 
a substituted nonstatutory stock option may be treated as a 
continuation of the initial option even where the holder of the option 
is not employed or otherwise providing services to the successor 
entity, provided the substitution otherwise meets the rules provided in 
the regulations.
6. Other Stock Right Issues
    The final regulations adopt certain definitions from the 
regulations governing statutory stock options, modified as appropriate 
for purposes of applying the rules under section 409A. These include 
the time and date of grant of an option (Sec.  1.421-1(c)), and the 
definitions of option (Sec.  1.421-1(a)), stock (Sec.  1.421-1(d)), 
exercise price (Sec.  1.424-1(e)), exercise (Sec.  1.421-1(f)), and 
transfer (Sec.  1.421-1(g)). These definitions apply by analogy to 
stock appreciation rights.
    The final regulations adopt the rule that a right to a payment of 
accumulated dividend equivalents at the time of the exercise of a stock 
right generally will be treated as a reduction in the exercise price of 
the stock right, causing the stock right to be deferred compensation 
subject to the requirements of section 409A. The final regulations 
provide that an arrangement to accumulate and pay dividend equivalents 
the payment of which is not contingent upon the exercise of a stock 
right may be treated as a separate arrangement for purposes of section 
409A. Such an arrangement generally will be required to comply with 
section 409A (unless it independently qualifies for an exception from 
coverage under section 409A), but will not affect whether the related 
stock right qualifies for the exclusion from coverage under section 
409A. The right to the dividend equivalents may be set forth within the 
stock right plan or the individual stock right grant, or in a separate 
document, as long as the payment of the dividend equivalents is not 
contingent upon the exercise of the stock right.
    Commentators also asked whether the exclusion of stock rights from 
coverage under section 409A would apply to tandem rights, meaning a 
stock right that combines a stock option right and a stock appreciation 
right, exercisable on an alternative basis. Similarly, commentators 
asked whether the substitution of a stock option for a stock 
appreciation right, or vice versa, where all the terms except the mode 
of payment upon exercise are similar, would be treated as a 
modification of a stock right. The application of section 409A 
generally is not affected by the medium of a taxable payment (for 
example, cash or stock). Accordingly, whether a stock right is 
expressed as a tandem arrangement under which the exercise of one right 
terminates the other right, or there is a substitution of a stock 
appreciation right for a stock option identical in all respects except 
for the medium of payment, generally does not impact whether the 
arrangement is excluded from coverage under section 409A.
    Commentators requested further clarification of the application of 
section 409A to stock option gain deferrals. The ability to defer gain 
upon the exercise or exchange (including a purported forfeiture) of a 
stock right is incompatible with the exclusion of certain stock rights 
from the requirements of section 409A because such exclusion is 
predicated on the option not having any additional deferral feature. 
Accordingly, if an arrangement provides for a potential to defer the 
payment of cash or property upon the exercise or exchange of a stock 
right beyond the year the right is exercised or beyond the original 
term of the stock right, the arrangement provides for a deferral 
feature and must comply with the requirements of section 409A from the 
time the legally binding right granted by the award arises.
    Because a stock option with a deferral feature is subject to 
section 409A regardless of whether the deferral feature is actually 
utilized, an option that includes a provision permitting deferral of 
option gain generally will not satisfy the time and form of payment 
rules under section 409A if the service provider can exercise the 
option in more than one taxable year. If a deferral feature is added to 
a preexisting option, the option will be treated as having included a 
deferral feature as of the original date of grant, generally resulting 
in a violation of section 409A.

[[Page 19243]]

    However, the final regulations provide that a stock right will not 
be treated as having a deferral feature where the service recipient 
delays a payment because the making of the payment would violate 
applicable Federal, state, local, or foreign law or jeopardize the 
ability of the service recipient to continue as a going concern. 
Although these provisions permit the delay for purposes of section 
409A, no inference should be drawn as to the Federal tax consequences 
of such a delay under any other section of the Code or Federal tax 
doctrine such as section 83, section 451, the constructive receipt 
doctrine, or the economic benefit doctrine.
    Commentators requested that the definition of service recipient 
stock be expanded to include the stock of a corporation for which a 
service recipient provides substantial services, at least with respect 
to a service provider of the service recipient that is providing 
services to the corporation. The legislative history does not support 
such a broad interpretation of service recipient stock, and the final 
regulations do not adopt this suggestion.
E. Restricted Property
    The final regulations provide, as did the proposed regulations, 
that a grant of restricted property generally will not constitute a 
deferral of compensation for purposes of section 409A. Commentators 
requested that the regulations clarify that a vested right to receive 
nonvested property in a future year does not constitute deferred 
compensation. Commentators argued that a right to receive nonvested 
property is not truly vested. For example, commentators argued that a 
right to receive restricted stock that will be subject to a substantial 
risk of forfeiture until the service provider completes three years of 
future services cannot be a vested right. The final regulations adopt 
this suggestion, so long as the risk of forfeiture to which the stock 
is subject constitutes a substantial risk of forfeiture for purposes of 
section 409A.
    Commentators specifically requested clarification of the 
circumstances under which a service provider may elect to be paid a 
bonus or other payment in the form of restricted stock, rather than 
cash. Generally an election between compensation alternatives, none of 
which provides for a deferral of compensation within the meaning of 
section 409A, will not cause the election to be subject to the section 
409A timing restrictions. Thus, a choice between an award of restricted 
stock or stock options that are not subject to section 409A will not be 
governed by the section 409A election timing rules. However, where any 
of the alternatives involves a deferral of compensation subject to 
section 409A, the election must comply with the provisions of section 
409A. In addition, no inference should be drawn as to the Federal tax 
consequences of such an election provision under any other section of 
the Code or Federal tax doctrine such as section 83, section 451, the 
constructive receipt doctrine, or the economic benefit doctrine.
F. Section 402(b) Trusts
    The final regulations continue to except from coverage under 
section 409A transfers of a beneficial interest in a trust, or a 
transfer to or from a trust, to the extent such a transfer is subject 
to section 402(b). The final regulations further clarify that a right 
to compensation required to be included in income under section 
402(b)(4)(A) (alternative taxation of highly compensated employees of a 
section 402(b) trust that fails to meet the requirements of section 
401(a)(26) or section 410(b)) also is not a deferral of compensation. 
However, a right to receive a benefit formulated as a right to a future 
contribution to a section 402(b) trust is similar to a right to receive 
property in a future taxable year, and generally would constitute 
deferred compensation.
G. Arrangements Between Partnerships and Partners
    The proposed regulations did not address the application of section 
409A to arrangements between partnerships and partners, and these final 
regulations also do not address such arrangements. The statute and the 
legislative history of section 409A do not specifically address 
arrangements between partnerships and partners providing services to a 
partnership and do not explicitly exclude such arrangements from the 
application of section 409A. Commentators raised a number of issues, 
relating both to the scope of the arrangements subject to section 409A 
and the coordination of the provisions of subchapter K and section 409A 
with respect to those arrangements that are subject to section 409A. 
The Treasury Department and the IRS are continuing to analyze the 
issues raised in this area. Notice 2005-1, Q&A-7 provides interim 
guidance regarding the application of section 409A to arrangements 
between partnerships and partners. Until further guidance is issued, 
taxpayers may continue to rely on Notice 2005-1, Q&A-7 and section 
II.E. of the preamble to the proposed regulations.
    Notice 2005-1, Q&A-7 provided that until further guidance is issued 
for purposes of section 409A, taxpayers may treat the issuance of a 
partnership interest (including a profits interest) or an option to 
purchase a partnership interest, granted in connection with the 
performance of services under the same principles that govern the 
issuance of stock. For this purpose, taxpayers may apply the principles 
applicable to stock options or stock appreciation rights under these 
final regulations, as effective and applicable, to equivalent rights 
with respect to partnership interests.
    Taxpayers also may continue to rely upon the explanation in the 
preamble to the proposed regulations regarding the application of 
section 409A to guaranteed payments for services described in section 
707(c). As stated in that preamble, until further guidance is issued, 
section 409A will apply to guaranteed payments described in section 
707(c) (and rights to receive such guaranteed payments in the future), 
only in cases where the guaranteed payment is for services and the 
partner providing services does not include the payment in income by 
the 15th day of the third month following the end of the taxable year 
of the partner in which the partner obtained a legally binding right to 
the guaranteed payment or, if later, the taxable year in which the 
right to the guaranteed payment is first no longer subject to a 
substantial risk of forfeiture.
    Commentators raised issues concerning the application of the 
provision in Notice 2005-1, Q&A-7 stating that until further guidance 
is issued, taxpayers may treat arrangements providing for payments 
subject to section 736 (payments to a retiring partner or a deceased 
partner's successor in interest) as not being subject to section 409A, 
except that an arrangement providing for payments that qualify as 
payments to a partner under section 1402(a)(10) is subject to section 
409A. Section 1402(a)(10) provides for an exception from the Self-
Employment Contributions Act (SECA) tax for payments to a retired 
partner, provided that certain conditions are met. Specifically, the 
payments must be made pursuant to a written plan of the partnership, 
must be on account of the partner's retirement and must continue at 
least until the partner's death. In addition, to qualify for the 
exception, the partner must not have rendered services during the 
partnership's taxable year ending within or with the partner's taxable 
year in which the amounts were received, as of the close of the 
partnership's taxable year no obligation

[[Page 19244]]

must exist from the other partners to such retired partner except with 
respect to retirement payments under such plan, and before the end of 
the partnership's taxable year such retired partner's share, if any, of 
the capital of the partnership must have been paid to him in full.
    Commentators questioned the appropriateness of the inclusion of 
such arrangements under section 409A, because neither the statute nor 
the legislative history refers to section 1402(a)(10). However, the 
Treasury Department and the IRS believe it is appropriate for such 
arrangements to be subject to section 409A because such arrangements 
are purposefully created to provide deferred compensation, and do not 
raise issues regarding the coordination of the provisions of section 
409A with the provisions of section 736, specifically the rules 
governing the classification of payments to a retired partner under 
section 736(a) (payments considered as distributive share or guaranteed 
payments) and section 736(b) (payments for interest in partnership).
    However, further clarification and relief is provided concerning 
the application of the deferral election timing rules to these 
payments. Until further guidance is issued, for purposes of section 
409A, taxpayers may treat the legally binding right to the payments 
excludible from SECA tax under section 1402(a)(10) as arising on the 
last day of the partner's taxable year before the partner's first 
taxable year in which such payments are excludible from SECA tax under 
section 1402(a)(10), and the services for which the payments are 
compensation as performed in the partner's first taxable year in which 
such payments are excludible from SECA tax under section 1402(a)(10). 
Accordingly, for purposes of section 409A, the time and form of payment 
of such amounts generally may be established, including through an 
election to defer by the partner, on or before the final day of the 
partner's taxable year immediately preceding the partner's first 
taxable year in which such payments are excludible from SECA tax under 
section 1402(a)(10). However, this interim relief does not apply a 
second time where an amount paid under an arrangement in one year has 
been excluded from SECA tax under section 1402(a)(10), and an amount 
paid in a subsequent year has not been excluded from SECA tax under 
section 1402(a)(10) because, for example, the partner performed 
services in that subsequent year.
H. Foreign Plans
1. Plans Covered by an Applicable Treaty
    The proposed regulations provided an exclusion from the definition 
of a nonqualified deferred compensation plan for any scheme, trust, or 
arrangement maintained with respect to an individual where 
contributions made by or on behalf of such individual to such scheme, 
trust or arrangement are excludable for Federal income tax purposes 
under an applicable income tax treaty. The final regulations retain 
that exclusion and clarify that the exclusion applies to the extent 
contributions made by or on behalf of such individual to such scheme, 
trust, arrangement or plan, or credited allocations, accrued benefits, 
or earnings or other amounts constituting income, of such individual 
under such scheme, trust, arrangement or plan, are excludable by such 
individual for Federal income tax purposes pursuant to any bilateral 
income tax convention to which the United States is a party.
2. Exclusion for Benefits Earned Under a Broad-Based Foreign Retirement 
Plan
    The proposed regulations contained an exclusion from coverage under 
section 409A for amounts deferred under a broad-based foreign 
retirement plan, subject to certain conditions, including that the 
service provider not be eligible to participate in a qualified employer 
plan, and that if the person is a U.S. citizen or lawful permanent 
resident, the exception only applies to nonelective deferrals of 
foreign earned income (as defined in section 911(b)(1)) that do not 
exceed the limits under section 415(b) and (c) that would be applicable 
if the plan were a qualified plan. Deferrals by participants that are 
nonresident aliens are not subject to the limitation based on section 
415. The final regulations adopt this provision, subject to certain 
modifications.
    Many of the commentators requested expansion of the exclusion for 
broad-based foreign retirement plans. One commentator requested that 
the exclusion apply to U.S. citizens working in the United States for a 
foreign employer. The Treasury Department and the IRS do not believe 
such an exception is justified. However, the exception for U.S. 
citizens or lawful permanent residents has been expanded to cover 
nonelective deferrals of foreign earned income as defined in section 
911(b)(1) without regard to section 911(b)(1)(B)(iv) and without regard 
to the requirement that the income be attributable to services 
performed during the period described in section 911(d)(1)(A) or (B). 
Accordingly, the exception may now cover certain participation by a 
U.S. citizen or lawful permanent resident who works overseas during 
only part of a year, and therefore is not a bona fide resident of a 
foreign country for an uninterrupted period that includes an entire 
taxable year, or is not present in the foreign country at least 330 
full days during a period of 12 consecutive months.
    The regulations have also been modified to address nonqualified 
deferred compensation plans covering bona fide residents of a U.S. 
possession. Under the regulations a bona fide resident of a possession 
who participates in a broad-based foreign retirement plan is not 
subject to section 409A with respect to participation in such plan. In 
addition, a plan substantially all of the participants in which are 
bona fide residents of a possession is eligible to be treated as a 
broad-based foreign retirement plan, so that U.S. citizens and resident 
aliens (other than bona fide residents of a possession) who participate 
in such a plan may be eligible for the more limited exclusion for 
participation in a broad-based foreign retirement plan.
    Another commentator requested that the exclusion apply to a plan 
that otherwise meets the requirements for the exclusion, regardless of 
whether the plan is sponsored by a foreign or U.S. employer. This 
suggestion has been adopted in the final regulations.
    Other commentators requested further clarification and revision of 
certain of the requirements to qualify for the exclusion. One 
commentator requested a safe harbor treating any plan granted favorable 
tax treatment under the laws of a foreign jurisdiction as qualifying 
for the exclusion. The Treasury Department and the IRS believe this 
standard is both too broad and not administrable, and this suggestion 
has not been adopted in the final regulations.
    Another commentator requested that the regulations provide a safe 
harbor percentage for determining whether substantially all of a 
foreign plan's participants are nonresident aliens. The final 
regulations do not adopt such a provision. However, the final 
regulations clarify that in determining whether substantially all of a 
foreign plan's participants are nonresident aliens or bona fide 
residents of a possession, only active participants are considered. For 
this purpose, active participants include individuals who, under the 
terms of the plan and without further amendment or action by the plan 
sponsor, are eligible to make or receive contributions or accrue 
benefits under

[[Page 19245]]

the plan (even if the individual has elected not to participate in the 
plan).
    A similar standard applies to the requirement that the individual 
not be eligible to participate in a qualified employer plan. The final 
regulations provide that a service provider will be treated as eligible 
to participate in a qualified employer plan if, under the plan's terms 
and without further amendment or action by the plan sponsor, the 
service provider is eligible to make or receive contributions or accrue 
benefits under the plan (even if the service provider has elected not 
to participate in the plan).
    The final regulations also clarify that the exclusion for United 
States citizens and lawful permanent residents applies to nonelective 
deferrals even if elective deferrals are permitted under the same plan, 
provided that the amounts deferred through nonelective deferrals and 
earnings on such amounts are distinguishable from amounts deferred 
through elective deferrals and earnings on such amounts, such as 
through the use of separate accounts.
3. Tax Equalization Payments
    The proposed regulations excluded from coverage under section 409A 
certain arrangements, referred to as tax equalization arrangements, 
that provide for payments intended to compensate the service provider 
for the excess of taxes actually imposed by a foreign jurisdiction on 
the compensation paid over the taxes that would be imposed if the 
compensation were subject solely to United States Federal income tax, 
subject to certain requirements. The final regulations adopt these 
provisions, subject to modifications. Based upon the comments received, 
the final regulations generally expand the exclusion in two respects. 
First, the final regulations extend the tax equalization payments 
exception to cover reimbursements of U.S. taxes that exceed foreign 
taxes. Second, the final regulations provide that the payment must be 
made by the end of the second taxable year of the service provider 
following the latest of the deadline for filing a U.S. Federal tax 
return or the deadline for filing foreign tax returns (or if a foreign 
return is not required to be filed, the due date for foreign tax 
payments) reflecting the compensation for which the tax equalization 
payment is provided.
    Commentators also asked how such reimbursement agreements could 
address the potential for an audit or other tax controversy, both in 
the U.S. and abroad. The same issue arises with respect to tax gross-up 
payments in general. For a discussion of the treatment of the right to 
such payments, see section VII.B.4 of this preamble.
4. Certain Limited Deferrals by Nonresident Aliens
    The proposed regulations provided an exception for amounts deferred 
by a nonresident alien under a foreign plan maintained by a foreign 
service recipient, to the extent the amounts deferred during the year 
did not exceed $10,000. The final regulations adopt this provision, 
subject to the modifications described in this preamble. In response to 
comments, the final regulations clarify that the exception applies to 
amounts deferred in that taxable year up to the specified limit, 
regardless of whether additional amounts are deferred. In making this 
modification, the exclusion provision has been moved from the section 
providing a definition of nonqualified deferred compensation plan 
(Sec.  1.409A-1(a)) to the section providing a definition of an amount 
deferred (Sec.  1.409A-1(b)). In addition, the final regulations 
clarify that this exception applies to earnings on amounts deferred 
that were subject to the exception, provided that the taxpayer can 
identify both the deferred amounts excepted and the applicable 
earnings. Finally, in response to comments requesting that the limit be 
increased and indexed, the final regulations increase the limit for the 
small deferral exception to the limit provided for elective deferrals 
under section 402(g).
    The small deferral exception is intended to provide relief to 
service providers that are not U.S. citizens or lawful permanent 
residents, are participating in a foreign plan, and perform services in 
the U.S. for which they are compensated. In such cases, the nonresident 
alien may inadvertently defer a relatively small amount of compensation 
that would otherwise be subject to U.S. Federal income tax. This may 
occur where the service provider defers the compensation that the 
service provider would otherwise have been paid for a brief period of 
service in the United States, or where the service provider receives 
service or compensation credit for a brief period of service in the 
United States under a benefit formula of a nonqualified deferred 
compensation plan.
    Some commentators requested that the exemption be extended to cover 
all amounts deferred by nonresident aliens under foreign plans to the 
extent the nonresident alien provides only temporary services in the 
U.S. Where the compensation earned by such a nonresident alien would be 
subject to U.S. income tax if paid when earned, the Treasury Department 
and the IRS do not believe that such a broad exception is warranted.
5. Other Foreign Plans
    The final regulations adopt the exclusion in the proposed 
regulations for deferrals of amounts that would be excluded as foreign 
earned income under section 911 if the amounts had been paid out when 
earned. The final regulations clarify that the amount is limited to an 
amount equal to or less than the difference between the maximum section 
911 exclusion for the year and the amount actually excluded for the 
year. Commentators requested that the exception for the deferral of 
amounts that would be excluded under section 911 be relaxed, so that 
U.S. expatriates who return for periods longer than 30 days or who earn 
compensation for services performed in the U.S. that is not excluded as 
foreign earned income, may also take advantage of the exception. This 
exception was not intended to address such plans. Rather, the provision 
was intended to provide relief from the section 409A requirements for 
U.S. expatriates who intend to work full-time outside the U.S. for 
compensation that is less than the exclusion amount under section 911, 
because it would severely disadvantage such workers to expect them to 
request that their potential foreign employers modify standard plans to 
accommodate them, or to expect such workers to otherwise be able to 
determine how to avoid or comply with section 409A.
    Commentators pointed out, however, that earnings on deferred 
amounts, including increases in amounts deferred under a nonaccount 
balance plan solely due to the passage of time, may not be treated as 
earned income under section 911 and argued that, nonetheless, such 
amounts should not lower the amount otherwise available to be deferred 
under the exception. The final regulations generally provide that 
rights to earnings credited on amounts that qualify for this exception 
are also excepted from coverage under section 409A, provided that the 
earnings satisfy the definition of earnings in Sec.  1.409A-1(o).
I. Indemnification Arrangements
    The final regulations generally provide that the right to the 
payment of contingent amounts pursuant to a service recipient's 
indemnification for expenses incurred as a result of a legal claim for 
damages related to the service provider's performance as a service 
provider, to the extent permissible under applicable law, will not be 
treated as the right to deferred compensation. Similarly, a right to 
liability insurance

[[Page 19246]]

coverage providing for such payments in the event of such a suit also 
will not be treated as providing for a deferral of compensation.
J. Separation Pay Plans
1. In General
    The final regulations generally adopt the provisions addressing 
separation pay plans set forth in the proposed regulations, subject to 
certain modifications. The final regulations clarify that separation 
pay refers only to compensation to which the service provider's right 
is conditioned upon a separation from service (including a separation 
from service due to death or disability) and not to compensation the 
service provider could receive without separating from service (such as 
an amount also payable upon a change in control, as a result of an 
unforeseeable emergency, or on a date certain). For example, the right 
to a gross-up payment for taxes payable due to the application of 
section 280G will constitute separation pay if a separation from 
service is required to obtain the payment. The final regulations also 
clarify that a separation pay plan for purposes of section 409A, 
including for purposes of the plan aggregation rules, refers only to 
plans providing for payments of amounts of deferred compensation 
(disregarding the exceptions from the definition of deferred 
compensation for certain types of separation pay) where one of the 
conditions to the right to the payment is a separation from service. A 
right to a payment upon a separation from service that is not deferred 
compensation does not become subject to section 409A under the plan 
aggregation rule. For example, the accelerated vesting due to a 
separation from service of stock options excluded from coverage under 
section 409A would not constitute a separation pay plan or otherwise 
become subject to section 409A under the plan aggregation rules.
    The final regulations generally retain and supplement the various 
exceptions from the definition of deferred compensation for certain 
types of separation pay, providing exceptions for (1) certain bona fide 
collectively bargained arrangements, (2) certain arrangements providing 
separation pay due solely to an involuntary separation from service or 
participation in a window program in limited amounts and for a limited 
period of time, (3) certain foreign separation pay arrangements, (4) 
certain reimbursement arrangements providing for expense reimbursements 
or in-kind benefits for a limited period of time following a separation 
from service, and (5) certain rights to limited amounts of separation 
pay. These exceptions from coverage under section 409A for specified 
separation pay plans may be used in combination. For example, the 
rights of an employee to the maximum amount available under the 
exception for separation payments made solely due to involuntary 
separation from service or participation in a window program, to 
reimbursements for reasonable moving expenses and outplacement expenses 
that meet the requirement for exclusion from coverage under section 
409A, and to rights to payments that do not exceed the limit on 
elective deferrals under section 402(g) and accordingly qualify for the 
limited payment exception, may all be excluded from coverage under 
section 409A due to application of the various exceptions.
    The final regulations continue to provide that any amount, or 
entitlement to any amount, that acts as a substitute for, or 
replacement of, amounts deferred under a separate nonqualified deferred 
compensation plan constitutes a payment of deferred compensation or 
deferral of compensation under the separate nonqualified deferred 
compensation plan. Commentators asked how this would apply where the 
service provider would otherwise forfeit a payment upon separation from 
service but a payment is made anyway, in whole or in part.
    The regulations provide that if a separation from service is 
voluntary, it is presumed that the payment results from an acceleration 
of vesting followed by a payment of the deferred compensation that is 
subject to section 409A. Accordingly, any change in the payment 
schedule to accelerate or defer the payments would be subject to the 
rules of section 409A. The presumption that a right to a payment is not 
a new right, but is instead a right substituted for an existing 
nonvested right, may be rebutted by demonstrating that the service 
provider's right to the payment after the separation from service would 
have existed regardless of the forfeiture of the nonvested right. 
Factors indicating that a right would have existed regardless of the 
forfeiture include that the amount to which the service provider 
obtains a right is materially less than the present value of the 
forfeited amount multiplied by a fraction, the numerator of which is 
the period of service the service provider actually completed, and the 
denominator of which is the full period of service the service provider 
would have been required to complete to receive the full amount of the 
payment. Another factor is that the payment consists of a type of 
payment customarily made to service providers who separate from service 
with that service recipient and do not forfeit nonvested rights to 
deferred compensation (for example, a payment of accrued but unused 
leave or a payment for a release of potential claims).
2. Separation Pay Due Solely to Involuntary Separation From Service or 
Participation in a Window Program
    The final regulations generally continue the exception from 
coverage under section 409A in the proposed regulations for rights to 
payments available only upon an involuntary separation from service or 
participation in a window program, payable no later than the end of the 
second taxable year of the service provider following the year of the 
separation from service, and limited to an amount that is generally the 
lesser of two times the service provider's annual compensation or two 
times the limit on compensation set forth in section 401(a)(17). This 
exception only applies where the payment is available solely due to an 
involuntary separation from service of the service provider, or the 
service provider's participation in a window program, and not to a plan 
providing for a payment upon a voluntary separation from service or 
other event. For a discussion of when a separation from service for 
good reason may be treated as an involuntary separation from service, 
see section III.J.3 of this preamble.
    Commentators requested that the exclusion continue to apply to 
payments up to the limit, even where the entire amount of the 
separation payments exceeds the limit. The final regulations adopt this 
rule. Accordingly, where a service provider is entitled to a payment 
that qualifies for the exception except that it exceeds the limit, only 
the excess over the limit will be subject to section 409A. The right to 
the payment up to the applicable limit will not be subject to section 
409A, including the requirement that the payment be delayed for six 
months in the case of a specified employee, provided that such limited 
payment is otherwise required to be made, and is made, no later than 
the end of the second taxable year following the service provider's 
taxable year in which the separation from service occurs.
    The final regulations clarify that for purposes of applying the 
section 401(a)(17) limit, the statutory limit applicable for the year 
of the separation from service occurs applies. The final

[[Page 19247]]

regulations also clarify that for purposes of determining the service 
provider's annual rate of pay for the taxable year preceding the 
taxable year in which the separation from service occurs, an annual 
rate of pay based upon the service provider's taxable year immediately 
preceding the service provider's taxable year in which the separation 
from service occurs is used, adjusted for any increase during the year 
that was expected to continue indefinitely if the service provider had 
not separated from service. One commentator requested that the limit be 
set at twice the amount of compensation set forth under section 
401(a)(17), regardless of the service provider's actual income. This 
suggestion has not been adopted in the final regulations.
3. Definition of Involuntary Separation From Service
    The proposed regulations provided an exclusion from coverage under 
section 409A that applied only to certain amounts paid solely because 
of an actual involuntary separation from service or participation in a 
window program. Many comments asked how to determine whether a 
separation from service is involuntary for this purpose. The final 
regulations contain a definition of involuntary separation from service 
and also apply this definition for purposes of the definition of a 
substantial risk of forfeiture, pursuant to which a payment that will 
not be made unless the service provider experiences an involuntary 
separation from service is subject to a substantial risk of forfeiture 
for purposes of section 409A. (See section V of this preamble.)
    The final regulations provide that whether a separation from 
service is involuntary is determined based on all the facts and 
circumstances. For this purpose, any characterization of the separation 
from service as voluntary or involuntary by the service provider and 
the service recipient in the documentation relating to the separation 
from service is rebuttably presumed to properly characterize the nature 
of the separation from service. For example, if a separation from 
service is characterized as voluntary, the presumption may be rebutted 
by demonstrating that absent the voluntary separation from service the 
service recipient would have terminated the service provider's 
services, and that the service provider had knowledge that the service 
provider would be so terminated.
    Commentators requested that a separation from service for good 
reason be treated as an involuntary separation from service. The final 
regulations provide that where the right to a payment is contingent 
upon a voluntary separation from service following an occurrence that 
constitutes good reason for the service provider to terminate his or 
her services, the right may be treated as payable only upon an 
involuntary separation from service where the good reason condition is 
such that the service provider's separation from service effectively is 
an involuntary separation for purposes of section 409A. To be treated 
as an involuntary separation for purposes of section 409A, the 
avoidance of the requirements of section 409A must not be a purpose of 
the inclusion of any good reason condition in the plan or of the 
actions by the service recipient in connection with the satisfaction of 
a condition. In addition, such good reason condition must require 
actions taken by the service recipient resulting in a material negative 
change in the employment relationship, such as a material negative 
change in the duties to be performed, the conditions under which such 
duties are to be performed, or the compensation to be received. 
Additional factors that may be relevant to whether a purported 
separation from service for good reason is the result of a bona fide 
good reason condition not having as a principal purpose the avoidance 
of section 409A include the extent to which the payments upon a 
separation from service for good reason are in the same amount and are 
made at the same time and in the same form as payments available upon 
an actual involuntary separation from service, and whether the service 
provider is required to give the service recipient notice of the 
existence of the good reason condition and a reasonable opportunity to 
remedy the condition. Where a good reason condition is sufficient to be 
treated for purposes of section 409A as a condition requiring an 
involuntary separation from service, an amount payable on account of a 
separation from service for good reason will be treated the same as an 
amount payable on account of an actual involuntary separation from 
service.
    The final regulations also provide a safe harbor under which a 
provision for a payment upon a voluntary separation from service for 
good reason will be treated for purposes of section 409A as providing 
for a payment upon an actual involuntary separation from service. Those 
conditions include that the amount be payable only if the service 
provider separates from service within a limited period of time not to 
exceed one year following the initial existence of the good reason 
condition, and that the amount, time and form of payment upon a 
voluntary separation from service for good reason be identical to the 
amount, time and form of payment upon an involuntary separation from 
service. In addition, the service provider must be required to provide 
notice of the existence of the good reason condition within a period 
not to exceed 90 days of its initial existence, and the service 
recipient must be provided a period of at least 30 days during which it 
may remedy the good reason condition. For these purposes, a good reason 
condition may consist of one or more of the following conditions 
arising without the consent of the service provider: (1) A material 
diminution in the service provider's base compensation; (2) a material 
diminution in the service provider's authority, duties, or 
responsibilities; (3) a material diminution in the authority, duties, 
or responsibilities of the supervisor to whom the service provider is 
required to report, including a requirement that a service provider 
report to a corporate officer or employee instead of reporting directly 
to the board of directors of a corporation (or similar entity with 
respect to an entity other than a corporation); (4) a material 
diminution in the budget over which the service provider retains 
authority; (5) a material change in geographic location at which the 
service provider must perform the services; or (6) any other action or 
inaction that constitutes a material breach of the terms of an 
applicable employment agreement.
4. Collectively Bargained Plans
    Commentators requested an exception from coverage under section 
409A to address certain plans providing for payments upon a voluntary 
separation from service, in the context of a collective bargaining 
agreement covering services performed for multiple employers. The 
Treasury Department and the IRS believe these issues are better 
addressed in the definition of separation from service. See section 
VII.C.2.b of this preamble.
5. Treatment as a Separate Plan
    For purposes of the plan aggregation rules, the final regulations 
provide for separate treatment of plans providing for separation pay 
solely due to an involuntary separation from service or participation 
in a window program. This exception is intended to apply only where the 
amounts are payable solely due to an involuntary separation from 
service or participation in a window program, and not where the amounts 
may also become payable for some other reason, even where such payments 
actually are made due to an involuntary

[[Page 19248]]

separation from service or participation in a window program. 
Accordingly, any amount that would be paid as a result of a voluntary 
separation from service will not be included in this category. An 
arrangement that does not provide for deferred compensation will not be 
aggregated with a deferred compensation plan under this rule, merely 
because the arrangement not providing for deferred compensation 
accelerates vesting or payment upon an involuntary separation from 
service (for example, the acceleration of the vesting of a stock option 
or stock appreciation right that is excluded from coverage under 
section 409A).
6. Reimbursement and Fringe Benefit Plans
a. In General
    The proposed regulations provided that certain plans under which a 
service recipient reimburses certain types of expenses (for example, 
reasonable moving expenses or reasonable outplacement expenses directly 
related to a termination of the service provider's services) actually 
incurred by a service provider (including certain in-kind benefits 
provided to the service provider) following a separation from service 
are not nonqualified deferred compensation plans for purposes of 
section 409A, if such reimbursements are available only for expenses 
incurred, and the reimbursements are made during a limited period 
(generally not after the second taxable year of the service provider 
following the separation from service).
    In response to questions from commentators, the final regulations 
clarify that a right to a benefit that is excludible from income will 
not be treated as a deferral of compensation for purposes of section 
409A. Accordingly, for example, an arrangement to provide health 
coverage excludible from income under section 105 generally would not 
be subject to section 409A.
    Many commentators requested increased flexibility to provide for 
reimbursement arrangements upon a separation from service, including 
certain requests to exempt broad categories of such arrangements, such 
as the continuation of any plan in which the service provider 
participated while performing services. The Treasury Department and the 
IRS believe that an exemption from coverage under section 409A is not 
appropriate in such circumstances, because such plans may provide for 
rights to significant amounts of deferred compensation over lengthy 
periods of time. However, the final regulations extend the limited 
period during which taxable reimbursements of medical expenses may be 
provided, to cover the period during which the service provider would 
be entitled (or would, but for such arrangement, be entitled) to 
continuation coverage under a group health plan of the service 
recipient under section 4980B (COBRA) if the service provider elected 
such coverage and paid the applicable premiums. In addition, the final 
regulations contain several provisions governing reimbursement plans 
(including plans providing in-kind benefits) that constitute 
nonqualified deferred compensation plans for purposes of section 409A, 
so that taxpayers will be able to design such arrangements to comply 
with the payment timing requirements of section 409A. For a discussion 
of these provisions, see section VII.B.2 of this preamble.
b. Specific Exceptions for Post-Separation Reimbursement Plans
    The final regulations continue to exclude from coverage under 
section 409A the reimbursement of certain expenses such as reasonable 
outplacement expenses and reasonable moving expenses for a limited 
period of time due to a separation from service, whether the separation 
from service is voluntary or involuntary. The final regulations, like 
the proposed regulations, require that the eligible expense must be 
incurred by the service provider no later than the end of the second 
year following the year in which the separation from service occurs. In 
response to questions from commentators, the final regulations clarify 
that the exception applies to the qualifying reimbursements available 
during the limited period of time, even if the plan extends beyond the 
limited period of time.
    Several commentators requested that the limited period of time 
refer solely to the time the expense is incurred, and not the time the 
expense is reimbursed, to reflect the need for time to process the 
reimbursement request. Although the final regulations do not adopt this 
suggestion, the final regulations extend the period during which a 
service provider can receive a reimbursement payment by providing that 
such payments must be made not later than the end of the third year 
following the separation from service. This extension applies only to 
reimbursements of expenses incurred by the service provider. Where the 
service recipient provides in-kind benefits (as defined in the 
regulations), or the service recipient pays a third party to provide 
in-kind benefits, such benefits must be provided by the end of the 
second year following the separation from service.
    Commentators also requested that the final regulations clarify the 
treatment of rights to a reimbursement of any loss incurred due to a 
sale of a residence. The regulations clarify that for this purpose, 
reasonable moving expenses include the reimbursement of an amount 
related to a loss incurred due to a sale of a primary residence, 
provided that the reimbursement does not exceed the loss actually 
incurred.
7. Limited Payments of Separation Pay
    The final regulations provide that, if not otherwise excluded, a 
taxpayer may treat a right or rights under a separation pay plan to a 
payment or payments of an aggregate amount not to exceed the applicable 
dollar amount under section 402(g)(1)(B) for the year of the separation 
from service as not providing for a deferral of compensation. 
Commentators raised questions concerning the calculation of the 
excluded amount, and requested an increase in the amount. The limited 
payment exception is intended to avoid the application of section 409A 
to incidental benefits often provided upon a separation from service, 
where the parties may not realize that the benefits are nonqualified 
deferred compensation. The exception is not intended to address 
extended or significant benefits. Accordingly, the final regulations do 
not substantially increase the amount of the exclusion. However, to 
permit the excluded amount to automatically reflect cost-of-living 
increases, the maximum exclusion now equals the maximum amount of an 
elective deferral permitted under section 402(g) for the year of the 
separation from service.
    The aggregate amount refers to the aggregate amount of payments to 
which the service provider has a right or rights. The exclusion may be 
applied to any type of separation pay plan, but may apply only once 
with respect to amounts paid by a service recipient to a service 
provider. So, for example, if a service provider treats a right to a 
payment of separation pay equal to the applicable limit under section 
402(g) in the first year following a separation from service as an 
excluded right, the right to the amount is not treated as a deferral of 
compensation regardless of when the amount is actually paid (though 
other provisions of the Code and the constructive receipt doctrine 
continue to apply). However, once the right is treated as excluded, the 
service provider may not treat any other right with respect to the 
service recipient, such as an additional right to a payment equal to 
the applicable limit under

[[Page 19249]]

section 402(g) in the second year following the separation from 
service, as excluded under this exception.
K. Non-Taxable Benefits
    The final regulations clarify that a legally binding right to 
receive a nontaxable benefit does not provide for a deferral of 
compensation for purposes of section 409A, unless the service provider 
has received the right in exchange for, or has the right to exchange 
the right for, an amount that will be includible in income (other than 
due to participation in a cafeteria plan described in section 125). In 
addition, because such benefits do not provide for a deferral of 
compensation, the plan aggregation rules will not result in taxation of 
other benefit plans merely because the terms of such nontaxable benefit 
arrangements would not comply with section 409A if the arrangement were 
covered by section 409A. For a discussion of the requirements for a 
taxable reimbursement plan to satisfy the payment timing requirements 
of section 409A, see section VII.B.2. of this preamble.
L. Legal Settlements
    Commentators requested clarification of the application of section 
409A to amounts paid pursuant to litigation between the service 
provider and service recipient, including both court awards and bona 
fide settlements, and including amounts characterized as wages or 
otherwise treated as replacing compensation. The Treasury Department 
and the IRS believe that section 409A was not intended to govern 
settlements or awards resolving bona fide legal claims based on 
wrongful termination, employment discrimination, the Fair Labor 
Standards Act, or worker's compensation statutes, regardless of whether 
such claims arise under Federal, state, local, or foreign laws, even 
where settlements or awards pursuant to such claims are treated as 
compensation for Federal tax purposes. The final regulations generally 
treat such arrangements as not providing for deferred compensation for 
purposes of section 409A. In addition, the final regulations generally 
provide that section 409A does not apply to the payment of, or 
reimbursement for, attorney's fees incurred in connection with the 
enforcement of such a claim. However, the exception covers only rights 
arising from the bona fide claim, and is not intended to allow such 
settlements or awards to act as substitutes for, or to allow for the 
restructuring of, preexisting deferred compensation subject to section 
409A. For example, a change to the timing of the payment of a pre-
existing amount of deferred compensation as part of such a settlement 
would be subject to the rules governing accelerated payments and 
subsequent deferral elections. In addition, the payment of an amount 
upon the execution of a waiver of any or all of such claims does not 
necessarily indicate that the amounts are paid as an award or 
settlement of an actual bona fide claim. Rather, to qualify for the 
exception under this provision, the amounts must be paid with respect 
to an actual bona fide claim for damages under the applicable law. For 
a discussion of the treatment of settlements of bona fide disputes 
regarding the right to preexisting deferred compensation subject to 
section 409A, see section VIII.G of this preamble.
M. Split-Dollar Life Insurance Arrangements
    Some commentators requested that split-dollar life insurance 
arrangements be excluded from coverage under section 409A. Split-dollar 
life insurance arrangements are often used as a method of providing 
deferred compensation and there is no indication in the statute or 
legislative history of any legislative intent that such arrangements be 
excluded from coverage under section 409A. In addition, like a promise 
to transfer property in the future, a promise to transfer an economic 
benefit in the future may provide for deferred compensation. 
Accordingly, a split-dollar life insurance arrangement may provide for 
deferred compensation, and whether a split-dollar life insurance 
arrangement provides for deferred compensation must be determined 
through application of the general rules defining deferred compensation 
and a nonqualified deferred compensation plan. In response to requests 
for additional guidance, the Treasury Department and the IRS anticipate 
issuing a notice addressing the application of section 409A to split-
dollar life insurance arrangements.
    Commentators raised issues concerning the interplay between the 
modifications that may be needed to satisfy the requirements of section 
409A and the effective date rules applicable to split-dollar life 
insurance arrangements under Sec.  1.61-22(j). Commentators pointed out 
that the modifications necessary to meet the requirements of section 
409A and these regulations may cause the arrangement to be treated as a 
new arrangement under Sec.  1.61-22(j) and requested relief. The notice 
will also address this issue.
N. Educational Benefits
    Commentators requested an exclusion from coverage under section 
409A for promises to provide future taxable educational benefits to 
service providers. These benefits typically would be provided as an 
inducement to provide a period of services. Commentators expressed 
concern that the amount and timing of the payment of such benefits 
would be difficult to ascertain, because the amount and timing of the 
payments would depend upon the service provider's decisions with 
respect to further education. The final regulations generally provide 
an exception from coverage under section 409A for rights to educational 
benefits, where the benefits consist solely of educational assistance 
(as defined for purposes of section 127(c)) provided solely for the 
education of the service provider.

IV. Definition of Plan

A. Plan Aggregation Rules
    The proposed regulations generally provided that all amounts 
deferred with respect to a service provider under all plans of a 
service recipient falling within a particular category would be treated 
as deferred under a single plan. The enumerated categories included 
amounts deferred under account balance plans, amounts deferred under 
nonaccount balance plans, amounts deferred under separation pay plans 
providing payments due solely to an involuntary termination or 
participation in a window program, and amounts deferred under any other 
plan. The final regulations adopt these provisions, subject to certain 
modifications described in this preamble.
    The final regulations provide that the bifurcation rules applicable 
to plans under Sec.  31.3121(v)(2)-1(c)(1)(iii)(B), which are 
permissive for purposes of the application of section 3121(v)(2), must 
be applied for purposes of the plan aggregation rules under section 
409A. Accordingly, a portion of a nonqualified deferred compensation 
plan is a separate account balance plan if that portion otherwise 
qualifies as an account balance plan and the amount payable to service 
providers under that portion is determined independently of the amount 
payable under the other portion of the plan.
    The final regulations also provide additional categories of plans 
for purposes of the aggregation rules. One category covers split-dollar 
life insurance arrangements. Another category is comprised of 
reimbursement plans, providing for the reimbursement of expenses 
incurred or the provision of

[[Page 19250]]

in-kind benefits (as defined in the regulations), to the extent the 
right to such benefits or reimbursements, separately or in the 
aggregate, does not constitute a substantial portion of the overall 
compensation earned by the service provider for performing services for 
the service recipient, or the overall compensation received due to a 
separation from service. Stock rights that constitute nonqualified 
deferred compensation for purposes of section 409A also comprise a 
separate category.
    The final regulations further provide for account balance plans to 
be subdivided into a category for elective plans and a category for 
nonelective plans. Plans will only be subdivided in this manner to the 
extent the amounts deferred under an elective deferral arrangement (and 
earnings on such amounts) may be separately identified. For this 
purpose, a right to a match on an elective deferral will not be treated 
as an elective deferral arrangement.
    In an additional category, any amounts deferred under a foreign 
plan may be treated as deferred under a separate plan from any amounts 
deferred under a domestic plan, provided that the deferrals under the 
plan are deferrals of amounts that would be treated as modified foreign 
earned income (meaning foreign earned income as defined under section 
911(b)(1) without regard to section 911(b)(1)(B)(iv) and without regard 
to the requirement that the income be attributable to services 
performed during the period described in section 911(d)(1)(A) or (B)) 
if paid to the service provider at the time the amount is first 
deferred, and provided further that the foreign plan is not 
substantially identical to a domestic plan in which the service 
provider participates. For this purpose, a foreign plan is a plan that 
the service recipient provides primarily to 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)).
B. Written Plan Requirement
    Commentators requested clarification and simplification of the 
provisions required to be included in writing in plan documents to 
comply with section 409A. As a general rule, the final regulations 
provide that to satisfy the requirement that a plan be in writing, the 
document or documents constituting the plan must specify, at the time 
an amount is deferred, the amount to which the service provider has a 
right to be paid (or, in the case of an amount determinable under an 
objective, nondiscretionary formula, the terms of such formula), and 
the payment schedule or payment triggering events that will result in a 
payment of the amount.
    A plan must provide for the six-month delay requirement applicable 
to payments to specified employees upon a separation from service no 
later than the time the provision may become applicable to a separation 
from service of the specified employee. Accordingly, the plan must 
contain the provision by the time at which the employee becomes a 
specified employee (either because the stock of a component of the 
service recipient becomes publicly traded, or because the specified 
employee effective date has been reached for a list of specified 
employees that includes the employee). A provision applicable to a plan 
sponsored by a service recipient or a plan in which a specified 
employee participates is effective with respect to a specified employee 
only to the extent the provision is binding on the employee.
    With respect to a deferral election, whether an initial or 
subsequent deferral election, the plan must specify no later than the 
time by which that election is required to be irrevocable the 
conditions under which that election may be made. With respect to 
permitted accelerations of a payment, the plan need not specify the 
conditions under which the accelerated payment will be made except as 
explicitly required in these regulations. However, the taxpayer must 
demonstrate that the acceleration of the payment complies with the 
requirements of section 409A and these regulations.
    Commentators also requested clarification regarding whether the 
requirement that a plan be in writing also means that the plan must be 
contained in a single document. For purposes of this rule, the plan 
consists of all documents that together define the service provider's 
rights to the compensation. Accordingly, the terms of a plan document 
may be contained in more than one document including, for example, a 
deferral election document.
    Commentators asked whether a savings clause would be sufficient to 
ensure compliance with section 409A, where the savings clause provides 
that each provision of the plan will be interpreted to be consistent 
with the requirements of section 409A and that any provision of the 
plan that does not satisfy such requirements will be of no force or 
effect. The final regulations provide that for purposes of determining 
the terms of a plan, general provisions of the plan that purport to 
nullify noncompliant plan terms, or to supply required specific plan 
terms, are disregarded. Accordingly, if a plan contains terms that do 
not meet the requirements of section 409A and these regulations, or 
fails to contain a plan term necessary to meet the requirements of 
section 409A and these regulations, the plan will violate the 
requirements of section 409A and these regulations regardless of 
whether the plan contains such a savings clause.
    Several commentators requested that the Treasury Department and the 
IRS publish model amendments. Due to the complex and varied universe of 
deferred compensation plans, the Treasury Department and the IRS do not 
believe that it is feasible to publish model amendments at this time.

V. Definition of Substantial Risk of Forfeiture

A. In General
    The final regulations generally adopt the definition of substantial 
risk of forfeiture set forth in the proposed regulations. Several 
commentators requested that the definition of substantial risk of 
forfeiture be the same as the definition of substantial risk of 
forfeiture in Sec.  1.83-3(c). However, the definition of substantial 
risk of forfeiture for purposes of compensatory transfers of property 
under section 83 reflects different policy concerns from those involved 
in section 409A, and there are also practical differences between 
transfers of restricted property and promises to pay deferred 
compensation. This is reflected in the provisions of section 
409A(e)(5), directing the Secretary of the Treasury Department to issue 
regulations disregarding a substantial risk of forfeiture in cases 
where necessary to carry out the purposes of section 409A. Accordingly, 
the final regulations do not adopt this suggestion.
    A right to an amount deferred may be subject to the satisfaction of 
two or more different conditions that each independently would be a 
substantial risk of forfeiture. In that case, the substantial risk of 
forfeiture generally would continue until all of such conditions had 
been met. Alternatively, a right to an amount deferred may be subject 
to the satisfaction of any of two or more different conditions that 
each independently would constitute a substantial risk of forfeiture. 
In that case, the substantial risk of forfeiture generally would lapse 
as soon as one of the conditions had been met.
    The final regulations explicitly provide that a payment conditioned 
on an involuntary separation from service without cause may be treated 
as subject

[[Page 19251]]

to a substantial risk of forfeiture if there is a substantial risk that 
the service provider will not be involuntarily separated from service 
without cause. Many of the comments relating to the definition of a 
substantial risk of forfeiture requested also that a benefit available 
only upon a separation from service for good reason be treated as 
subject to a substantial risk of forfeiture. Under the definition of an 
involuntary separation from service provided in the final regulations, 
the right to a payment upon a separation for service for good reason 
may, in certain circumstances, be treated as a right to a payment upon 
an involuntary separation from service. For a discussion of the 
definition of an involuntary separation from service, see section 
III.J.3 of this preamble.
    Commentators requested that a requirement that an employee sign a 
release of claims to receive a benefit be treated as a substantial risk 
of forfeiture. Generally, conditions under the discretionary control of 
the service provider (other than the decision whether or not to 
continue providing services) are not treated as creating a substantial 
risk of forfeiture. Accordingly, the final regulations do not adopt 
this suggestion.
    One commentator suggested that any right to a payment be treated as 
subject to a substantial risk of forfeiture until the amount of the 
payment is readily determinable, at least where the payment could be 
zero. The Treasury Department and the IRS do not believe that this 
standard is appropriate.
B. Election Between Vested and Nonvested Rights
    The final regulations provide that an amount will not be considered 
subject to a substantial risk of forfeiture after the date or time at 
which the recipient otherwise could have elected to receive the amount 
of compensation, unless the present value of the amount purportedly 
subject to a substantial risk of forfeiture (disregarding, in 
calculating the present value, the risk of forfeiture) is materially 
greater than the present value of the vested amount the recipient 
otherwise could have elected to receive. For example, if a service 
provider can elect to receive, in lieu of a payment of current 
compensation, a bonus based upon a formula that would otherwise subject 
the bonus to a substantial risk of forfeiture, the bonus will be 
subject to a substantial risk of forfeiture for purposes of section 
409A only if the present value of the amount of the bonus (disregarding 
the risk of forfeiture) is materially greater than the present value of 
the current compensation amount.
    Some commentators asked whether this exception addressed the 
extension of a substantial risk of forfeiture as part of the negotiated 
extension of an employment contract. Commentators argued that rights a 
service provider obtains under a new or extended employment contract 
could be viewed as a right to an amount materially greater than the 
amount the service provider otherwise could have received. The final 
regulations clarify that for purposes of this rule, compensation the 
service provider would receive for continuing to perform services 
regardless of whether the service provider elected to receive the 
vested payment is not taken into account for purposes of determining 
whether the present value of the right to the nonvested payment is 
materially greater.

VI. Initial Deferral Election Rules

A. In General
    The final regulations adopt the provisions contained in the 
proposed regulations relating to initial deferral elections, subject to 
the modifications described in this preamble.
    The proposed regulations generally provided that in a nonelective 
plan, a service recipient may designate the time and form of payment on 
or before the date the service provider obtains a legally binding right 
to the payment. Commentators requested clarification of how the service 
recipient's discretion to designate a time and form of payment related 
to the requirement in the proposed regulations that a service 
provider's deferral election be irrevocable by the applicable deadline. 
Specifically, commentators requested that a deferral election by a 
service provider be treated as irrevocable, even if during the period 
during which the service recipient could have set the time and form of 
payment (that is, through the date the service recipient grants the 
service provider a legally binding right to the payment), the service 
recipient retains the right to override the service provider's deferral 
election and provide for deferral of a lesser or greater amount. The 
final regulations do not adopt this suggestion. If a service provider 
may make an initial deferral election, including an election as to the 
time and form of payment, the election must be irrevocable as of the 
date required under the rules governing such service provider 
elections. Accordingly, a plan may not provide for such an override, 
unless such override cannot occur after the deadline by which the 
service provider's election must be effective.
    Many commentators requested a clarification of the rules with 
respect to a deferral of a discretionary bonus, where the legally 
binding right to the bonus does not arise until a year subsequent to 
the year in which services are performed. For example, an employer 
announces in 2010 that it will be awarding discretionary bonuses for 
services performed in 2011, and will decide which employees will 
receive bonuses and in what amounts at the beginning of 2012. Section 
409A(a)(4) generally provides that compensation for services performed 
during a taxable 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 taxable year preceding the year in which 
the services are rendered. Accordingly, even where the bonus is 
discretionary such that the legally binding right to the bonus does not 
arise until after the period of services for which the bonus is paid 
has begun, a service provider's deferral election must occur before the 
year in which the period of services begins absent some other 
applicable exception (such as, for example, the deferral election rules 
related to performance-based compensation). The determination of the 
period of services for which compensation is earned is based on all the 
facts and circumstances, but may include periods of service before the 
date the service provider obtains a legally binding right to the 
compensation. Although not necessarily determinative, one of the 
factors taken into account in that determination is a designation by 
the service recipient of the period of services for which the 
compensation is earned.
B. Nonelective Deferrals
    Commentators pointed out that under the proposed regulations, a 
service recipient might be required to designate a time and form of 
payment with respect to a nonelective deferral at an earlier date than 
the service provider would have to make such a designation if an 
election had been provided to the service provider. Commentators 
requested that the service recipient be provided the same flexibility 
as the service provider in such cases. The final regulations generally 
adopt this suggestion, so that if the service provider has no election 
as to the time and form of payment of an amount of deferred 
compensation, the service recipient may set the time and form of 
payment on any date on or before the later of the latest date the 
service provider would have been permitted under these regulations to 
elect such time and form of payment if an election had been provided to 
the service

[[Page 19252]]

provider, or the date the service recipient grants the legally binding 
right to the compensation. So, for example, where compensation is 
performance-based compensation, and the service recipient retains the 
discretion to establish the time and form of the payment, the plan 
generally could permit the service recipient to establish the time and 
form of the payment on or before the date six months before the end of 
the relevant performance period.
C. Performance-Based Compensation
    The final regulations generally adopt the definition of 
performance-based compensation contained in the proposed regulations, 
subject to the modifications described in this preamble. The final 
regulations clarify that where a portion of an award would qualify as 
performance-based compensation if the portion were the sole amount 
available under the plan, that portion of the award will not fail to 
qualify as performance-based compensation merely because another 
portion of the award does not qualify as performance-based 
compensation, if the portion that would qualify as performance-based 
compensation is designated separately or otherwise separately 
identifiable under the terms of the plan and each portion is determined 
independently of the other.
    Commentators asked whether in order to use the deferral rules 
regarding performance-based compensation, a service provider must be 
required to perform services during the entire performance period, or 
from the date the performance criteria are set through the end of the 
performance period. Commentators argued that because a payment cannot 
be substantially certain to be made at the time of the deferral 
election under the deferral election rules applicable to performance-
based compensation, a service provider's ability to manipulate the 
timing of income inclusion under a performance-based compensation 
arrangement is limited. The final regulations require only that the 
service provider provide services from the later of the date the 
performance period starts or the date the performance criteria are 
established through the date the initial deferral election is made.
    Commentators suggested that a provision in a plan for automatic 
payment to occur upon death, disability, or a change in control event 
(as defined for purposes of section 409A) should not result in a 
failure of the arrangement to qualify as performance-based 
compensation. The final regulations adopt this suggestion, provided 
that where such an event occurs before a deferral election has been 
made, the right to the payment will no longer be treated as 
performance-based compensation so that a deferral election may not be 
effective unless made in accordance with another applicable deferral 
election rule.
    In response to comments, the requirement that a deferral election 
under the rule applicable to performance-based compensation be made 
before the compensation has become substantially certain to be paid has 
been modified, and now requires that the election be made before the 
amount is readily ascertainable. Where the right to a specified amount 
is subject to a performance requirement being met (for example, a right 
to a payment of $10,000 if a certain profit level is attained), the 
amount is treated as readily ascertainable when it is substantially 
certain that the performance requirement will be met. With respect to 
the right to an amount of compensation that varies based upon the level 
of performance, the payment, or any portion of the payment, is treated 
as readily ascertainable to the extent the amount or the payment is 
calculable and the performance requirement is substantially certain to 
be met. For this purpose, a right to a payment is bifurcated between 
the amount that is readily ascertainable and the amount that is not 
readily ascertainable. Accordingly, any minimum amount that is 
calculable and for which the performance requirement entitling the 
service provider to the payment is substantially certain to be met 
generally will be treated as readily ascertainable.
    For example, a service recipient agrees to pay $100 for every 
additional widget meeting certain quality requirements that is produced 
in a calendar year in excess of 100 widgets. At the end of the six 
months, 125 widgets have been produced and no election to defer has 
been made. As of that date, the performance-based compensation with 
respect to which an election to defer can be made does not include the 
$2500 ((125-100) multiplied by $100) that is calculable and for which 
the performance requirement is substantially certain to be met. In 
addition, the performance-based compensation does not include any 
additional amount that the service provider is substantially certain to 
earn based on the number of additional widgets that the service 
provider is substantially certain to produce before the end of the 
year. However, the payment is bifurcated so that any additional amount 
that is not substantially certain to be paid may be treated as 
performance-based compensation such that an election to defer such 
compensation may be made.
    Commentators requested clarification of the circumstances under 
which compensation, the amount of which is determined by reference to 
the value of service recipient stock, may qualify as performance-based 
compensation. The fair market value of stock at any given time 
generally incorporates the market's perception of the probability that 
the stock will increase or decrease in value. Accordingly, compensation 
payable for a service period that is equal to the value of a 
predetermined number of shares of stock, and is variable only to the 
extent that the value of such shares appreciates or depreciates, 
generally will not be performance-based compensation. However, if the 
right to such compensation is subject to a performance-based vesting 
requirement, such compensation may be performance-based compensation. 
Also, the attainment of a prescribed value for the service recipient 
(or a portion thereof), or a share of stock of the service recipient, 
may be used as a performance-based criterion, if it is a condition for 
receiving the compensation and the other requirements are met.
D. Initial Eligibility
    Section 409A(a)(4)(B)(ii) provides that in the case of the first 
year in which a service provider becomes eligible to participate in the 
plan, an initial deferral election may be made within 30 days after the 
date the service provider becomes eligible to participate in the plan, 
with respect to compensation for services to be performed subsequent to 
the election. The final regulations adopt the provisions implementing 
the initial eligibility deferral election rules set forth in the 
proposed regulations, subject to the following modifications.
    Many of the commentators on the initial eligibility deferral 
election rule expressed concerns about the application of the plan 
aggregation rules. The proposed regulations provided that the plan 
aggregation rules would apply in determining whether a service provider 
was newly eligible for a plan, so that if a service provider was 
already participating in an arrangement that is required to be 
aggregated with the arrangement for which the service provider is 
initially eligible, the service provider would not be able to take 
advantage of the initial eligibility deferral election rule. Some 
commentators requested that the plan aggregation rules not apply for 
this purpose. However, the Treasury Department and the IRS believe that 
such a rule would result in the potential

[[Page 19253]]

for the adoption of serial plans as a means to claim repeated initial 
eligibility and the ability thereby to make late deferral elections. In 
addition, such a rule would require difficult determinations of whether 
one plan was sufficiently dissimilar from another plan to qualify as a 
separate plan.
    Other commentators requested that the plan aggregation rules apply, 
but that plans allowing elections between current and deferred 
compensation, or the part of a plan allowing such elections, be treated 
separately from nonelective plans or nonelective benefits in each 
category. The final regulations generally adopt this rule through the 
modifications to the plan aggregation rules described in section IV.A 
of this preamble.
    Other comments focused on the application of the initial 
eligibility deferral election rule in the case of a rehire or a change 
in position within a service recipient. Commentators pointed out that 
under the standard in the proposed regulations, if an employee had not 
received a distribution after the initial termination of employment, or 
had transferred to a position not participating in the plan without 
receiving a distribution and then transferred back to a position 
participating in the plan, the rehired or returning employee would 
still retain the right to benefits under the plan and thus would not be 
able to use the initial eligibility deferral election rules. The final 
regulations provide that the initial eligibility deferral election 
rules are applicable to a service provider provided that the service 
provider has not been an active participant in the plan (applying the 
plan aggregation rules) for at least 24 months. For this purpose, a 
service provider is an active participant in the plan if, under the 
plan's terms and without further amendment or action by the plan 
sponsor, the service provider is eligible to accrue benefits under the 
plan (even if the service provider has elected not to participate in 
the plan), other than earnings on amounts previously deferred.
    Commentators requested relief with respect to the timing rules for 
initial elections establishing the time and schedule of payments under 
nonelective excess benefit plans. Commentators noted that under such 
plans, a service provider often automatically becomes a participant 
when the service provider's benefits under the qualified plan become 
limited under the rules governing qualified plans. Because determining 
whether a service provider is a participant requires calculations, 
commentators observed that both the service provider and the service 
recipient may be unaware that the service provider has become a 
participant in the plan for some time after the service provider 
actually first becomes eligible. The final regulations generally 
provide that with respect to a nonelective excess benefit plan, a 
service provider is treated as initially eligible to participate in the 
plan as of the first day of the service provider's taxable year 
immediately following the first year the service provider accrues a 
benefit under such plan, so that an initial deferral election with 
respect to the time and form of payment may be effective for benefits 
accrued under the plan based on services performed during the taxable 
year immediately preceding the year in which the election is made. This 
rule may only be used once with respect to a service provider's 
participation in a plan.
E. Initial Deferral Elections With Respect to Certain Forfeitable 
Rights
    The proposed regulations provided a rule for initial deferral 
elections with respect to certain forfeitable rights, generally 
intended to address ad hoc awards. Under the rule in the proposed 
regulations, if a legally binding right to a payment in a subsequent 
year 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. The final regulations retain this rule, subject to the 
modifications described in this preamble.
    Commentators suggested that the requirement of at least a 12-month 
service period following the deferral election during which the right 
could be forfeited due to a separation from service be shortened to 11 
months, because the combination of the 30-day election period plus the 
12-month service period requirement generally resulted in a requirement 
of at least a 13-month performance period. The requirement of a 12-
month service period after an election is made ensures that the 
election occurs while at least an entire year (12 months) of services 
is still required. This conforms in many respects to the general rule 
that the deferral election must be made in the year before the year in 
which the services are performed. Any shorter period would permit 
service providers to make deferral elections in the same taxable year 
in which all of the services are performed. The Treasury Department and 
the IRS do not believe that such a rule is consistent with the 
legislative intent.
    The final regulations also provide that this rule is available even 
if the right to the compensation may vest earlier than 12 months 
following the election due to the service provider's death or 
disability, or due to a change in control event (as defined for 
purposes of section 409A) with respect to the service recipient. 
However, if death, disability, or a change in control event occurs and 
the condition lapses before the end of such 12-month period, a deferral 
election may be given effect only if the deferral election is permitted 
under the regulations without regard to this rule.
F. Initial Deferral Election With Respect to Fiscal Year Compensation
    The final regulations retain the initial deferral election rule 
with respect to fiscal year compensation that was in the proposed 
regulations. The final regulations clarify that the rule with respect 
to the deferral of fiscal year compensation is based upon the service 
recipient's taxable year, regardless of whether the service recipient's 
taxable year is the calendar year or some other period. Accordingly, 
where a service recipient with a calendar year taxable year is 
providing fiscal year compensation to a service provider based upon a 
calendar year, a service provider with a non-calendar year taxable year 
generally could take advantage of the rule to defer such fiscal year 
compensation on or before the December 31 preceding the calendar year 
upon which the fiscal year compensation is based.
G. Initial Deferral Elections With Respect to Commissions
    The final regulations continue to provide a special deferral 
election rule with respect to commission payments. These rules are 
intended to address concerns that, for many commission arrangements, it 
is difficult to determine when the services related to a particular 
commission payment began, so that it is difficult to apply the general 
rule that requires that a deferral election be made before the year in 
which any services are performed. This rule is not intended to address 
whether, absent such a deferral election, a particular commission 
arrangement would result in deferred compensation. Whether a commission 
arrangement otherwise provides for deferred compensation must be 
determined through the

[[Page 19254]]

application of the general rules defining deferred compensation. 
However, where a commission arrangement requires that the service 
provider be providing services at the time of the payment to be 
entitled to the payment, the commission is paid in the normal course, 
and neither the service provider nor the service recipient has a right 
to specify a payment date, the arrangement generally will not provide 
for the deferral of compensation.
    The final regulations generally adopt the deferral election rule 
set forth in the proposed regulations treating the services related to 
a commission payment as performed in the year in which the customer 
remits payment to the service recipient. For this purpose, the proposed 
regulations provided that commissions include only compensation 
contingent upon the service recipient receiving payment from an 
unrelated customer for the product or services provided.
    Commentators asked that this rule be extended to cover arrangements 
under which the service recipient paid the commission based upon 
consummation of a transaction, regardless of whether the customer paid 
the service recipient for the service or good purchased from the 
service recipient. For example, commentators stated that in some 
industries the service recipient pays a salesperson commissions based 
on the amount of sales recorded, even though the customer is not 
obligated to pay the service recipient until a later date. The final 
regulations generally adopt this suggestion by permitting the taxable 
year in which the sale occurs to be substituted for the year in which 
the customer remits payment. However, to avoid manipulation of the 
deferral election timing rules, the taxable year of the sale may be 
used only if it is applied consistently to all similarly situated 
service providers.
    Commentators also asked that this rule be extended to commissions 
earned due to the increase in value, or maintenance of overall value, 
of a pool of assets or accounts. In response, the final regulations 
provide that, for purposes of the initial deferral election rules, the 
services with respect to investment commission compensation are deemed 
to be performed over the 12 months immediately preceding the date as of 
which the overall value of the assets or asset accounts is determined 
for purposes of the calculation of the investment commission 
compensation. For this purpose, investment commission compensation 
means compensation earned by a service provider if a substantial 
portion of the services provided by such service provider to a service 
recipient consists of sales of financial products or the provision of 
other direct customer services to an unrelated customer with respect to 
customer assets or customer asset accounts. For this purpose, amounts 
will only be treated as investment commission compensation if the 
customer retains the right to terminate the customer relationship and 
transfer or withdraw the assets or asset accounts without undue delay 
(which may be subject to a reasonable notice period), the compensation 
paid by the service recipient to the service provider consists of a 
portion of the value of the overall assets or asset account balance, an 
amount substantially all of which is calculated by reference to the 
increase in the value of the overall assets or account balance during a 
specified period, or both, and the value of the overall assets or 
account balance and investment commission compensation is determined at 
least annually.
    Commentators also requested that the exception for commissions be 
expanded to address arrangements involving customers related to either 
the service provider or the service recipient. The Treasury Department 
and the IRS are concerned that where arrangements involve related 
parties, there is the potential for manipulation of the timing of the 
payment and the commission, but also understand that many of such 
arrangements may not involve abuse. Therefore, the final regulations 
provide that the special rules with respect to commissions apply to 
arrangements involving a customer related to the service provider or 
the service recipient provided that substantial sales or substantial 
services occur between the service recipient and a significant number 
of unrelated customers, and the sales or service arrangement and the 
commission arrangement with respect to a customer related to either the 
service recipient or the service provider are bona fide and arise in 
the ordinary course of business, and both the terms and practices are 
substantially the same as the terms and practices applicable to 
customers to whom the service provider and service recipient are not 
related, and to whom, either individually or in the aggregate, the 
service recipient has made substantial sales or provided substantial 
services.
H. Involuntary and Voluntary Separations From Service
    The final regulations provide that with respect to separation pay 
paid upon an actual involuntary separation from service, where the 
service provider had no prior right to such separation pay, and where 
the separation pay is the subject of bona fide, arm's length 
negotiations, the initial deferral election may be made at any time 
before the service provider obtains a legally binding right to the 
payment. The final regulations expand this rule to include voluntary 
separations from service as well as involuntary separations, as long as 
all of the other conditions in the previous sentence are met. The 
exception addresses both a choice between a current and a deferred 
payment, and the establishment of the time and form of payment of 
deferred compensation.
    The exception is intended to address legally binding rights to 
deferred compensation arising as part of the process of separating from 
service and not based upon previously existing legally binding rights. 
The exception is intended to alleviate concern that where such rights 
are expressed or calculated based on prior compensation or service, any 
election by the service provider as to the timing of the payment during 
the negotiation process could be viewed as a late initial deferral 
election made during or after the year in which the services were 
performed, and to avoid the potential for the plan aggregation rules to 
eliminate the ability to make an initial eligibility deferral election. 
The Treasury Department and the IRS have become aware that certain 
taxpayers have attempted to apply this provision to existing deferred 
compensation plans, believing that the exception allows new elections 
provided that the separation pay was the subject of bona fide 
negotiations. This application is inconsistent with the explicit 
provision of the proposed regulations and these final regulations. The 
provision does not address preexisting legally binding rights to 
deferred compensation, including legally binding rights that are 
subject to a substantial risk of forfeiture. Any change in the time and 
form of payments under those arrangements would be required to meet the 
rules governing subsequent deferral elections and accelerated payments 
(including any applicable relief provided during the transition 
period). For a discussion of the treatment of benefits forfeitable upon 
the separation from service, see section III.J.1 of this preamble.
I. Elections To Annualize Recurring Part-Year Compensation
    Commentators asked how the deferral election rules would apply to 
an election by certain employees providing services over less than a 
12-month period to receive payments for services on an annualized 
basis. For example, teachers performing services during a school year 
running from September of

[[Page 19255]]

one year through June of the next year often are provided an election 
to receive the compensation on an annualized basis over 12 months 
instead of during only the school year. This raises issues under the 
general initial deferral election rules under section 409A because the 
teacher is permitted to elect after the beginning of the calendar year 
to defer some of the compensation that would be paid in September 
through December of that year to a period in the subsequent year.
    The final regulations provide that with respect to recurring part-
year compensation, an election to defer all or a portion of the 
compensation to be earned during a particular period of service may be 
made at any time before the period of service begins, provided that no 
amounts are deferred under the election to a date after the last day of 
the 13th month following the first day of the performance period. For 
this purpose, recurring part-year compensation is defined as 
compensation paid for services rendered in a capacity that the service 
recipient reasonably anticipates will continue in subsequent years on 
similar terms and conditions, and will require services to be provided 
over successive service periods of less than 12 months, each of which 
begins in one taxable year of the service provider and ends in the next 
such taxable year. For example, a teacher earning compensation from 
September 15 of one year through June 30 of the subsequent year could 
elect to defer compensation earned during such period on any date on or 
before September 15 of the first year, provided that no amount deferred 
in accordance with this rule is deferred beyond October 31 of the 
following year. This exception may be applied to a particular amount of 
compensation only once, so that an amount deferred under this exception 
may not be deferred a second time through treatment of the amount as 
earned in a subsequent service period.
J. USERRA
    The final regulations provide that the initial deferral election 
rules are deemed satisfied to the extent that a deferral election 
provided to a service provider is necessary to satisfy the requirements 
of the Uniformed Services Employment and Reemployment Rights Act of 
1994, as amended, 38 U.S.C. 4301-4334. Similar relief has been provided 
with respect to changes in the time and form of payment and 
accelerations of payments.

VII. Time and Form of Payment

A. In General
    The final regulations clarify that except as explicitly provided 
otherwise, a single time and form of payment must be designated with 
respect to each payment that is payable upon a payment event. For 
example, a plan must designate how an amount will be paid upon a change 
in control event, and generally cannot provide one time and form of 
payment upon a particular type of change in control event, and another 
time and form of payment upon another type of change in control event. 
The final regulations retain the rule, however, that permits a plan to 
provide for a different time and form of payment, depending upon 
whether the permissible payment event occurs before or after a 
specified date. In addition, the final regulations also provide for a 
limited ability to designate different times and forms of payment based 
upon the conditions under which a service provider's separation from 
service occurs. See section VII.C.5. of this preamble for a discussion 
of payments upon a separation from service.
    The proposed regulations provide that for purposes of applying the 
payment rules, a payment will be treated as made on a fixed date or on 
a fixed schedule if the payment or payments are made by the end of the 
calendar year in which a specified fixed payment date, or due date of a 
payment under a fixed schedule, occurs or, if later, the 15th day of 
the third month following such fixed date or due date. The final 
regulations clarify that the same flexibility applies to making a 
payment on account of a payment event. So, for example, where a payment 
is scheduled to be made upon the death of a service provider whose 
taxable year is the calendar year, the payment is timely if made on or 
before the later of December 31 of the calendar year in which the death 
occurs, or the 15th day of the third month following the date of death. 
If the service provider's taxable year is not the calendar year, the 
final regulations specify that the service provider's taxable year is 
used for purposes of this rule.
    Commentators also requested that where a payment is scheduled to be 
made on a fixed date, a service recipient be permitted to pay at any 
preceding date within the same calendar year. Commentators argued that 
if the regulations permitted a payment to be made later within the same 
calendar year because the amount would be reflected on the same income 
tax return in the case of an individual service provider, then the same 
rationale should permit payments to be made earlier in the same 
calendar year. Because the adoption of this provision would conflict 
with the administration of the rules governing subsequent deferrals, 
the final regulations do not adopt this suggestion.
    The subsequent deferral rules require that any election to extend 
the deferral period must not be effective for at least one year after 
the date the payment is due. If a payment due on a specified date 
during a calendar year could always be made on January 1 or any 
subsequent date during the calendar year, then the one-year waiting 
period would have to begin to run on the previous January 1, regardless 
of the actual payment date the plan specified.
    For example, if a plan specified December 31 as the payment date, 
but the payment could be made on January 1, then any subsequent 
deferral election would need to be made on or before January 1 of the 
preceding calendar year, making the deadline for a subsequent deferral 
election almost two years before the actual specified payment date. 
Such a rule would unduly burden service providers who cannot actually 
receive a payment before the date specified in the plan. However, to 
lower the potential for unintentional violations, the final regulations 
provide that a payment will be deemed made at the scheduled time of 
payment if made not earlier than 30 days before the scheduled date, 
provided that the service provider is not permitted, directly or 
indirectly, to designate the taxable year of the payment.
    In addition, the final regulations continue to provide that a plan 
may designate an entire taxable year of the service provider, rather 
than a specific date, as the specified date of payment. If a plan 
provides only for the taxable year of payment, the payment may be made 
at any time during such year. For purposes of the subsequent deferral 
rules, the payment will be treated as scheduled to be paid on the first 
day of the service provider's taxable year.
    Commentators also requested clarification of the treatment of 
deadlines for payment, where the plan does not designate a specific 
payment date or taxable year of the service provider. For example, 
commentators asked whether a provision requiring payment as soon as 
administratively feasible but in no event later than the 15th day of 
the third month following the end of the year would be treated as 
having a fixed date of payment. The final regulations provide that such 
a provision will be a specified payment

[[Page 19256]]

date only if the period during which such payment may be made is 
restricted either to a specified taxable year of the service provider 
or a period of not more than 90 days and the service provider is not 
provided an election as to the taxable year of the payment. If a 
specific payment date is not established, the first possible date on 
which a payment could be made under the plan is the specified payment 
date for purposes of the rules relating to subsequent deferral 
elections. For example, a payment scheduled to be made at any time on 
or after January 1, 2008, and on or before July 1, 2008, to a service 
provider whose taxable year is the calendar year will be deemed to have 
a fixed payment date. For purposes of the subsequent deferral rules, 
January 1, 2008, is the specified payment date.
    By contrast, a payment scheduled to be made to such a service 
provider at any time on or before July 1, 2008, would not be deemed to 
have a fixed payment date, because the payment could be made before 
January 1, 2008. In addition, a payment scheduled to be made to a 
service provider, for example, within 180 days of a separation from 
service generally will not provide for a specified time and form of 
payment under the final regulations, because it specifies neither the 
taxable year of the service provider in which the payment must be made 
following the separation from service, nor a period of 90 days or less 
following the separation from service in which the payment must be 
made. Because such a payment schedule would not provide an objective 
payment date based upon the separation from service event, the payment 
also would not be eligible for the relief provided for payments made by 
the later of the end of the taxable year of the service provider or the 
15th day of the third month following the specified payment date. 
However, a plan provision providing that the payment will be made 
within 90 days of a separation from service generally will be treated 
as a specified payment date, and for purposes of the subsequent 
deferral rules the date of the separation from service will be treated 
as the scheduled payment date.
B. Specified Time or Fixed Schedule of Payments
1. In General
    The final regulations generally adopt the rules defining a 
specified time or fixed schedule of payments, including the ability to 
designate a service provider's taxable year as the year of payment 
rather than a specific date. For example, a plan provision providing 
for payment within the service provider's taxable year that includes 
December 31, 2008, would be treated as a fixed date of payment.
2. Reimbursement and In-Kind Benefit Plans
    Many commentators requested additional guidance regarding ways in 
which rights to taxable reimbursements or in-kind benefits might be 
structured to meet the definition of a fixed schedule of payments. In 
response, the final regulations provide that a right to reimbursements 
or in-kind benefits will meet the requirement of a fixed time and form 
of payment if certain requirements are satisfied. For this purpose, a 
reimbursement plan must provide for the reimbursement of expenses 
incurred during an objectively prescribed period (including a period 
beginning or ending based upon a service provider's death), where the 
amount of reimbursable expenses incurred or in-kind benefits available 
in one taxable year of the service provider cannot affect the amount of 
reimbursable expenses or in-kind benefits available in a different 
taxable year. In addition, the reimbursement payment must be made by no 
later than the end of the service provider's taxable year following the 
taxable year in which the expense is incurred. Such reimbursement or 
in-kind benefit rights may not be subject to liquidation or exchange 
for another benefit.
    For example, a right to a reimbursement of membership fees incurred 
for each of three specified and consecutive calendar years by a former 
employee, where the former employee is entitled to reimbursement of the 
expenses incurred each year without regard to the expenses incurred in 
a different year, and where the former employee cannot exchange the 
right for cash or any other benefit, generally will be treated as 
providing for a fixed time and form of payment if the plan requires 
that the reimbursement payment be made by no later than the end of the 
calendar year following the year in which the expense is incurred. In 
contrast, a right to reimbursement of membership fees of up to $30,000 
over three years would not meet the requirement of a fixed time and 
form of payment, because the extent to which the former employee 
incurred the expense in the first year would affect the amount 
available for reimbursement in a subsequent year.
    This rule applies similarly to the provision of in-kind benefits, 
such as a right to use a corporate vehicle or aircraft. The final 
regulations also provide a special rule for arrangements reimbursing 
medical expenses to permit certain aggregate limits on the benefits 
provided, such as lifetime maximums.
3. Payment Schedules With Fixed or Formula Payment Limitations
    Commentators asked whether payment schedules with fixed or 
objective formula limitations on the amount that may be paid during any 
particular period would meet the requirement of a fixed schedule or 
time and form of payment. Where the fixed or formula limitation is 
established on or before the date the time and form of payment is 
otherwise required to be set, the fixed or formula limitation is based 
on a fixed or nondiscretionary, objectively determinable formula 
limitation on the amount that may be paid in a particular period where 
all the factors relevant to the determination of such limit are beyond 
the control of the service provider and not subject to any exercise of 
discretion by the service recipient, and the plan specifies the time 
and form of payment of any additional amount due in excess of the fixed 
or formula limitation amount, the schedule will be deemed to be a fixed 
schedule of payments because it is not subject to manipulation. 
However, a change in the limits or a change in the allocation method 
for the payment of the unpaid excess amounts that will be paid after 
the original due dates due to application of the limit may constitute a 
subsequent deferral election or the acceleration of a payment. 
Similarly, where the total amount payable under a plan with multiple 
participants is limited, the time and form of payment requirement may 
be met if the plan specifies, from the date the time and form of 
payment is otherwise required to be set, the following: (1) A fixed or 
nondiscretionary, objectively determinable limit on the amount that may 
be paid in a particular period such that none of the factors relevant 
to the determination of such limit is in the control of the service 
provider or subject to the exercise of any discretion by the service 
recipient; (2) where there is an overall limitation on the aggregate 
amount that may be paid to a group of service providers during a 
specified period, a nondiscretionary, objectively determinable method 
to allocate the payments that can be made in accordance with the 
limitation among the service providers participating in the plan over 
which neither the service recipient nor any service provider retains 
control or discretion; and (3) the time and form of payment of any 
amount that will be paid after its original due date because of the 
formula limitation.

[[Page 19257]]

    For example, a plan may provide that all payments to all 
participants under the plan in a given year may not exceed $1 million, 
provided that the plan must provide an objective, nondiscretionary 
method of currently allocating the $1 million of payments if the 
amounts otherwise payable exceed $1 million (such as proportionately to 
each participant based on the amount otherwise payable to such 
participant absent the limit), and specifies the time and form of 
payment of any amount not paid currently because of the limitation 
(such as at the earliest time possible without exceeding the applicable 
limitation for any subsequent year). However, a change in the limits or 
a change in the allocation method may constitute a subsequent deferral 
election or an acceleration of a payment.
    Commentators also asked whether the same analysis would apply where 
the limit on a payment is calculated pursuant to a formula related to 
business performance, such as a specified percentage of cash flow for 
the period. A payment schedule may be conditioned on a formula 
limitation if the formula limitation is specified at the time the 
schedule of payments is otherwise required to be set, the limitation is 
nondiscretionary and objectively determinable based on the business 
performance of the service recipient, and the service provider retains 
no control over the determination or application of the formula 
limitation. For this purpose, a formula limitation based on profits or 
other indicia of general business performance is not treated as 
discretionary or in the control of the service recipient. Thus, a plan 
providing that the maximum payment during a year will equal no more 
than a set percentage of the service recipient's cash flow for the 
previous year generally would meet the requirement of a fixed time and 
form of payment. However, a change in the formula limitation may 
constitute a subsequent deferral election or an acceleration of a 
payment. For a discussion of schedules of payments based upon the 
timing of payments received by the service recipient, see section 
VII.B.6 of this preamble.
4. Tax Gross-Up Payments
    Commentators requested clarification of how section 409A applies to 
a right to a tax gross-up payment that provides the service provider 
with the right to a payment of taxes otherwise payable by the service 
provider as well as any additional taxes resulting from the service 
recipient's payment of the taxes. The final regulations provide that a 
right to a tax gross-up payment is a right to deferred compensation 
that satisfies the requirement of a fixed time and form of payment if 
the plan provides that the tax gross up payment will be made, and the 
payment is made, by the end of the service provider's taxable year next 
following the service provider's taxable year in which the related 
taxes are remitted to the taxing authority.
    In addition, the final regulations provide that a right to the 
reimbursement of expenses incurred due to a tax audit or litigation, 
whether Federal, state, local, or foreign, satisfies the requirement of 
a fixed time and form of payment if the right to the reimbursement 
provides that payment will be made, and the payment is made, by the 
later of the end of the service provider's taxable year next following 
the year in which the taxes that are the subject of the audit or 
litigation are remitted to the taxing authority, or, if no taxes are to 
be remitted, the end of the service provider's taxable year next 
following the year in which the audit or litigation is completed. 
Nothing in the provisions relating to tax gross-up payments modifies 
the application of section 409A to any underlying compensation 
arrangement that results in the taxes that are subject to the tax 
gross-up arrangement.
5. Payment Schedules Based on Payments to the Service Recipient
    Commentators requested guidance on payment schedules contingent on 
the receipt of certain payments by the service recipient. For example, 
commentators requested clarification whether a plan requiring an annual 
payment equal to a percentage of certain accounts receivable collected 
during the prior 12-month period would qualify as a fixed time and form 
of payment. The ability to schedule payments based upon the time the 
service recipient receives a customer's payment raises issues regarding 
the ability to, in effect, create an impermissible event-based payment 
through characterizing the payment as a schedule (for example, a 
payment ``schedule'' that pays an amount every year if a specified 
transaction occurs in that year actually pays based on whether and when 
the transaction occurs, which is not a permissible payment event under 
section 409A). In addition, these arrangements raise issues regarding 
the ability of the service recipient (or service provider) to control 
the timing of the payment of deferred compensation through an ability 
to influence the timing of the payment by the customer. Accordingly, 
the final regulations generally provide that a schedule based upon the 
timing of payments to the service recipient is not a fixed schedule of 
payments. However, the final regulations also provide certain 
parameters under which such a plan may qualify as having a fixed time 
and form of payment. First, if the service recipient is comprised of 
more than one entity, the payments must be due from a person that is 
not one of such entities (for example, not a payment due from a 
subsidiary corporation to a parent corporation). Second, the payments 
must stem from bona fide and routine transactions in the ordinary 
course of business of the service recipient, and the service provider 
must not at the time such payments are due retain effective control 
over the service recipient, the person from whom the payments to the 
service recipient are due, or the collection of the payments. Third, 
the payment schedule must provide for a nondiscretionary, objective 
method of identifying the customer payments to the service recipient 
from which the amount of the payment is determined, and a 
nondiscretionary, objective schedule under which payments of the 
nonqualified deferred compensation will be made (for example, a payment 
every March 1 of 10 percent of the accounts receivable collected during 
the previous calendar year). Finally, the sales to which the payment 
relates must be of a type that the service recipient is in the trade or 
business of making and makes frequently, and either all such sales must 
be taken into account or there must be a legitimate, nontax business 
purpose for limiting the sales taken into account.
C. Separation From Service
1. In General
    The final regulations generally adopt the provisions in the 
proposed regulations defining the circumstances under which a 
separation from service is deemed to occur, subject to the 
modifications described in this preamble. Some commentators requested 
that the parties to a nonqualified deferred compensation plan be 
permitted to define when a separation from service occurs, at least if 
they apply the definition consistently. The Treasury Department and IRS 
believe that a definition of separation from service that is 
objectively determinable, nondiscretionary and predictable, and not 
subject to negotiations between the parties is necessary to properly 
implement the legislative intent behind section 409A. The definitions 
of separation from service suggested by the commentators do not meet 
this standard. For example, a plan that defines separation from

[[Page 19258]]

service as the date a service provider is removed from a payroll would 
leave to the parties the discretion to determine a payment date by an 
action that may have little practical significance, especially when 
compared to the effect on the service provider's deferred compensation 
amounts. The Treasury Department and the IRS continue to believe that 
the definition of separation from service should be based upon an 
objective determination of whether the service provider continues to 
provide significant services to the service recipient.
2. Employees
a. In General
    The proposed regulations provided that an employee separated from 
service with the employer if the employee died, retired, or otherwise 
had a termination of employment with the employer. Whether a 
termination of employment had occurred would be determined based on the 
facts and circumstances. The proposed regulations provided that where 
the facts and circumstances indicated that the employer and the 
employee did not intend for the employee to provide more than 
insignificant future services, the employee would be treated as having 
a separation from service. For this purpose, an employer and employee 
would not be presumed to have intended only insignificant services be 
provided if the employee continued providing services at a rate equal 
to at least 20 percent of the rate of the previous three years. Where 
an employee continued providing services in another capacity (for 
example, as an independent contractor), the employee would be deemed 
not to have a separation from service if the service provider continued 
providing services at a rate equal to at least 50 percent of the 
services provided during the previous three years. Different rules were 
provided for service providers who were not employees.
    Commentators criticized this standard in various respects. The 
proposed regulations applied one presumption where an employee 
continued providing services as an independent contractor, and another 
where an employee continued providing services as an employee. 
Commentators asked why the same presumptions did not apply regardless 
of whether the employee purports to continue service (or separate from 
service) as an employee or purports to continue service (or separate 
from service) as an independent contractor. Commentators also suggested 
that the presumptions should be based on the intent of the employer and 
employee at the time of the purported separation from service (or 
purported continuation of services), rather than the actual subsequent 
conduct. Commentators also argued that the employer and employee could 
be found to have violated section 409A based on subsequent actual 
conduct, even where the parties had a bona fide belief that a 
separation from service had or had not occurred, but circumstances 
changed.
    In response to these comments, the final regulations provide a 
simplified standard, applicable whether an employee continues to 
provide services as an employee or as an independent contractor. The 
general standard for determining whether the employee has terminated 
employment is based on whether the facts and circumstances indicate 
that the service recipient and employee reasonably anticipated either 
that no further services would be performed after a certain date or 
that the level of bona fide services the employee would perform after 
such date (whether as an employee or as an independent contractor) 
would permanently decrease to no more than 20 percent of the average 
level of bona fide services performed over the immediately preceding 
36-month period (or the full period in which the employee provided 
services to the employer (whether as an employee or as an independent 
contractor) if the employee has been providing services for less than 
36 months). For this purpose, periods during which the employee is on 
an unpaid bona fide leave of absence are disregarded (including for 
purposes of determining the relevant 36-month period), and periods 
during which the employee is on a paid bona fide leave of absence are 
treated as periods during which the employee provided services at the 
level at which the employee would have been required to perform 
services to receive the compensation if not on a bona fide leave of 
absence. Facts and circumstances to be considered in determining 
whether the employee and employer reasonably anticipated that the 
service provider's future services would be permanently reduced to less 
than 20 percent of the average level of bona fide service provided 
during the previous 36-month period include, but are not limited to, 
whether the employee continues to be treated as an employee for other 
purposes (such as continuation of salary and participation in employee 
benefit programs), whether similarly situated service providers have 
been treated consistently, and whether the employee is eligible to 
perform services for, and realistically available to perform services 
for, other employers in the same line of business.
    To assist in applying this standard, certain rebuttable 
presumptions are provided. An employee generally will be presumed to 
have separated from service where the level of bona fide services 
performed (whether as an employee or an independent contractor) changes 
to a level equal to 20 percent or less of the average level of services 
provided during the previous 36 months (whether as an employee or an 
independent contractor). An employee will be presumed not to have 
separated from service where the level of bona fide services rendered 
continues at a level that is 50 percent or more of the average level of 
services provided during the previous 36 months. No presumption applies 
to a change to a level of services between 20 percent and 50 percent of 
the average level of services provided during the previous 36 months. 
For purposes of the presumption, the entire period during which the 
employee has provided services to the employer is substituted for 36 
months if the employee has been providing services to the employer for 
less than 36 months, and periods during which the employee is on a bona 
fide leave of absence are treated in the same manner as such periods 
are treated for the general rule.
    The presumptions are rebuttable, by demonstrating that the employer 
and the employee reasonably anticipated that as of a certain date the 
level of bona fide services would be reduced permanently to a level 
less than or equal to 20 percent of the average level of services 
provided during the immediately preceding 36-month period or full 
period in which the employee has provided services if the employee has 
been providing services to the employer for a period of less than 36 
months (or that the level of bona fide services would not be so 
reduced). For example, an employee may demonstrate that the service 
recipient and employee anticipated that the employee would cease 
providing services, but that (subsequent to the original cessation of 
services) business circumstances such as termination of the employee's 
replacement caused the employee to return to employment. Although the 
employee's return to employment may cause the employee to be presumed 
to have continued in employment because the rehired employee is 
providing services at a rate equal to the rate at which he was 
providing services before the termination of employment, the facts and 
circumstances in this case

[[Page 19259]]

would demonstrate that at the time the employee terminated employment, 
the employee and the service recipient reasonably anticipated that the 
employee would not provide any services in the future.
    Similarly, where the loss of a business client of the employer 
results in a permanent reduction in the level of bona fide services 
performed by the employee of more than 80 percent, so that the employee 
would be presumed to have separated from service, the taxpayer may 
rebut the presumption that a separation from service occurred by 
showing that the employer and employee reasonably anticipated that the 
level of services would not be so reduced. The separation from service 
would then be deemed to occur at the time that the employer and 
employee reasonably anticipated that such reduction would continue.
    Commentators requested additional flexibility to treat certain 
employees as having experienced a separation from service, even where 
the employee continues to provide services in a reduced capacity. This 
is often referred to as a phased retirement, in which an employee 
obtains retirement benefits despite continuing to provide services on a 
part-time or reduced basis. The Treasury Department and the IRS believe 
that providing flexibility to alter the definition of a separation from 
service after an amount has been deferred is inconsistent with the 
statute and legislative intent, and could be subject to manipulation.
    However, the final regulations permit certain flexibility for a 
plan to define a separation from service as including a change to a 
reduced level of bona fide services, if the definition is specified no 
later than the time and form of payment are elected or otherwise 
specified. Specifically, the final regulations provide that rather than 
treating a separation from service as requiring an anticipated 
permanent reduction in the level of bona fide services to 20 percent or 
less of the average level of bona fide services provided in the 
immediately preceding 36 months, a plan may treat another level of 
anticipated permanent reduction in the level of bona fide services as a 
separation from service, provided that the level of permanent reduction 
required must be set forth in the plan as a specific percentage, and 
the anticipated permanently reduced level of bona fide services must be 
greater than 20 percent but less than 50 percent of the average level 
of bona fide services provided in the immediately preceding 36 months. 
The plan must specify the definition of separation from service on or 
before the date at which a separation from service is designated as a 
time of payment of an amount deferred, and once designated, any change 
to the definition of separation from service with respect to such 
amount deferred will be subject to the rules regarding subsequent 
deferrals and the acceleration of payments.
    For example, on or before the time at which a plan must designate a 
time and form of payment for a deferred amount, the plan may specify 
that a separation from service will be deemed to occur at any time that 
the employee and employer reasonably anticipate that the bona fide 
level of services the employee will perform (whether as an employee or 
an independent contractor) will be permanently reduced to a level that 
is less than 50 percent of the average level of bona fide services the 
employee performed during the immediately preceding 36 months (or the 
entire period the employee has provided services if the employee has 
been providing services to the employer less than 36 months).
b. Identification of the Service Recipient
    Commentators requested that the definition of the term service 
recipient be expanded for purposes of determining whether a separation 
from service has occurred. The final regulations generally adopt this 
suggestion, so that for purposes of determining whether a service 
provider has separated from service with an employer or other service 
recipient, the service recipient is defined as including all entities 
that would be treated as part of the group of entities comprising the 
service recipient under section 414(b) and (c) and the accompanying 
regulations, but substituting a 50 percent ownership level for the 80 
percent ownership level in section 414(b) and (c) and the accompanying 
regulations. A plan may specify that a higher or lower percentage 
ownership level will be used, provided that the ownership level may not 
be higher than 80 percent or lower than 20 percent, and provided 
further that an ownership level of less than 50 percent may be used 
only where such use is based on legitimate business criteria. As 
discussed, the plan must specify the percentage on or before the date 
at which a separation from service is designated as a time of payment 
of the amount deferred, and where a plan changes the definition of 
separation from service with respect to amounts previously deferred, 
such a change will be subject to the rules governing changes to the 
time and form of payment, including the anti-acceleration provisions.
    Commentators also requested special treatment with respect to the 
identification of the service recipient in instances where an amount is 
deferred pursuant to a bona fide collective bargaining agreement 
covering service with multiple employers, and the employee may be 
expected to perform services covered by the bona fide collective 
bargaining agreement for a number of different employers. Specifically, 
commentators expressed concern that an employee not be treated as 
having separated from service when a particular period of service with 
an employer is completed, if the employee has made herself available to 
perform services covered by the bona fide collective bargaining 
agreement for another employer. The final regulations generally provide 
that where the amount is deferred pursuant to a plan provided under a 
bona fide collective bargaining agreement covering services with 
multiple employers, and where service providers may reasonably 
anticipate providing services for more than one of the participating 
employers, the plan may define a separation from service in a manner 
that treats the service provider as not having separated from service 
when the service provider stops performing services for one employer 
covered by the agreement and provides services for another employer 
covered by the agreement. The final regulations also provide that the 
plan may not treat a service provider as having separated from service 
during periods where the service provider is not providing services but 
has made herself available to perform services for a participating 
employer, provided that the definition requires that the service 
provider be deemed to have separated from service no later than the end 
of any 12-month period in which the service provider has not provided 
services covered by the bona fide collective bargaining agreement to 
any employer.
c. Bona Fide Leave
    Many of the comments with respect to the definition of separation 
from service for an employee concerned the treatment of bona fide 
leaves of absence. For purposes of determining whether a service 
provider has separated from service (and not for purposes of 
determining whether a vacation or sick leave plan is a bona fide 
vacation or sick leave plan), a bona fide leave of absence refers to a 
leave of absence where there is a reasonable expectation the service 
provider will return to service with the service recipient. The final 
regulations provide that an employment relationship is treated as 
continuing while the individual is on sick leave, or

[[Page 19260]]

other bona fide leave of absence, if the period of such leave does not 
exceed six months, or if longer, so long as the individual retains a 
right to reemployment with the service recipient under an applicable 
statute or by contract. For example, where a tenured professor takes a 
leave of absence, but the professor retains a right to reemployment 
with the university as part of the professor's tenured status, the 
professor will not be deemed to have terminated from employment merely 
due to the leave of absence from the university. If the period of leave 
exceeds six months and the individual does not retain a right to 
reemployment under an applicable statute or by contract, the employment 
relationship is deemed to terminate on the first date immediately 
following such six-month period. However, the final regulations modify 
the provisions in the proposed regulations with respect to disability 
leave. With respect to disability leave, the employment relationship 
will be treated as continuing for a period of up to 29 months, unless 
otherwise terminated by the employer or the employee, regardless of 
whether the employee retains a contractual right to reemployment. For 
this purpose, disability leave refers to leave due to the employee's 
inability to perform the duties of his or her position of employment or 
any substantially similar position of employment 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 six months.
d. Salary Continuation Programs and Terminal Leave
    Commentators requested that salary continuation programs be 
permitted to delay the occurrence of a separation from service, where 
an employee continues to receive salary and benefits and is otherwise 
treated as an employee, although not required to perform any further 
meaningful services. Some commentators also requested this treatment 
for terminal leave, or leave intended to bridge a service provider to a 
separation from service date that would permit continuation of benefits 
or accrual of additional benefits under, for example, a qualified plan. 
The Treasury Department and the IRS believe that these types of actions 
are subject to manipulation and should not delay the time when a 
service provider is treated as having separated from service for 
purposes of section 409A. Accordingly, the final regulations do not 
recognize extensions of leave or salary and benefits as a means of 
delaying the date of separation from service for purposes of section 
409A. In addition, terminal leave with no intent to return generally 
would not be treated as bona fide leave for purposes of the rule for 
employees addressing bona fide leave.
    Commentators expressed concern that the service recipient may wish 
to continue providing certain employee benefits, including in-kind 
benefits and reimbursement plans, during a salary continuation or 
terminal leave period. With respect to the application of section 409A, 
such plans generally may be structured to avoid providing for the 
deferral of compensation, or to provide deferred compensation in 
compliance with the requirements of section 409A. See sections III.J.6 
and VII.B.2 of this preamble. The definition of separation from service 
for purposes of section 409A is not applicable for purposes of other 
Code provisions, such as those provisions governing qualified 
retirement plans or non-taxable benefits.
e. Rehires and Suspensions of Benefits
    Commentators also requested that the regulations address rehires, 
and specifically whether payments of deferred compensation could be 
suspended during a subsequent period of employment or other service 
until a subsequent separation from service. Such a suspension generally 
would violate the rules governing changes in the time and form of 
payment because payments would be delayed in a manner that does not 
satisfy the rules applicable to subsequent deferral elections. Neither 
the statutory language of section 409A nor the legislative history 
indicates any intent to permit such additional flexibility. Moreover, 
the Treasury Department and the IRS believe that suspension of benefits 
rules would add significant complexity to the administration of the 
Code section. However, many of the desired results of a suspension of 
benefits provision often may be obtained through deferrals of future 
compensation after rehire.
f. Mergers and Acquisitions
    Comments with respect to the application of the separation from 
service standard in the case of a merger or acquisition generally 
focused on two areas. First, commentators requested that the final 
regulations adopt permissive use of the rule generally referred to as 
the ``same desk'' rule, allowing the parties to an asset purchase 
agreement to decide whether employees of the selling corporation that 
continue in the same position with the purchaser of the assets will be 
treated as separating from service. The final regulations adopt a rule 
providing that where as part of a sale of assets by one service 
recipient (seller) to an unrelated service recipient (buyer), a service 
provider of the seller would otherwise experience a separation from 
service with the seller, the seller and the buyer may specify whether a 
service provider providing services to the seller immediately before 
the asset purchase transaction and providing services to the buyer 
after and in connection with the asset purchase transaction has 
experienced a separation from service, provided that the asset purchase 
transaction results from bona fide, arm's length negotiations, all 
service providers providing services to the seller immediately before 
the asset purchase transaction and providing services to the buyer 
after and in connection with the asset purchase transaction are treated 
consistently (regardless of position at the seller) for purposes of 
applying the provisions of any nonqualified deferred compensation plan, 
and such treatment is specified no later than the closing date of the 
asset purchase transaction. For this purpose, a sale of assets refers 
to a transfer of substantial assets, such as a plant or division or 
substantially all of the assets of a trade or business.
    Second, commentators requested clarification whether a spin-off of 
a subsidiary could result in a separation from service of an employee 
of the subsidiary, where the nonqualified deferred compensation plan 
defines a separation from service as including any action resulting in 
the employee no longer being an employee of the controlled group of 
corporations including the parent corporation. Generally such a 
transaction would not result in a termination of employment for an 
employee of the subsidiary, because the employee is continuing 
employment with the same employer both before and after the 
transaction. However, the rules that provide a service recipient 
discretion to terminate and liquidate a plan following a change in 
control transaction afford taxpayers the flexibility to pay out their 
deferred compensation liabilities in particular circumstances. See 
section VIII.B of this preamble.
3. Directors
    The final regulations provide generally that where a service 
provider provides services to a service recipient both as an employee 
and as an independent contractor, the service provider must separate 
from service both as an employee and as an independent contractor to be 
treated as having separated from service. But where a service provider 
provides services both as an employee and a

[[Page 19261]]

member of the board of directors of a corporate service recipient, the 
services provided as a director are not taken into account for purposes 
of determining whether the service provider has a separation from 
service as an employee for purposes of a nonqualified deferred 
compensation plan in which the service provider participates in his or 
her capacity as an employee that is not aggregated with any plan in 
which the service provider participates as a director. Accordingly, 
where an employee-director participates in a separate plan as an 
employee, his or her termination of services as an employee will 
constitute a separation from service for purposes of the employee plan, 
regardless of whether he or she continues providing services as a 
director (and vice versa). However, if a non-employee director is also 
providing additional services as an independent contractor, he or she 
cannot have a separation from service for purposes of section 409A 
until he or she has separated from service both as a director and as an 
independent contractor.
4. Delay for Specified Employees
    Section 409A(a)(2)(B) provides that with respect to a specified 
employee, a payment of nonqualified deferred compensation on account of 
separation from service may not occur before the date that is six 
months after the date of separation from service (or, if earlier, the 
date of death of the employee). For this purpose, a specified employee 
is a key employee of a corporation any stock of which is publicly 
traded on an established securities market or otherwise. With respect 
to identifying specified employees, the final regulations generally 
adopt the provisions set forth in the proposed regulations, subject to 
the modifications and clarifications described in this preamble.
a. Identification of Specified Employees
    Several commentators asked whether an employee may be subject to 
the six-month delay requirement if the service recipient stock is 
publicly traded only on a foreign exchange or is traded on a U.S. 
exchange only as American depositary receipts or American depositary 
shares (ADRs). The final regulations define an established securities 
market for purposes of the six-month delay rule by reference to the 
rules in Sec.  1.897-1(m), which generally include foreign securities 
markets. Accordingly, the six-month delay may apply to an employee of a 
service recipient the stock of which is publicly traded solely on a 
foreign exchange, or is traded on a U.S. exchange only as ADRs. In the 
case of a service recipient comprised of multiple entities, this rule 
would apply if one of the entities had stock that was publicly traded 
on a foreign exchange.
    Some commentators requested that the final regulations provide that 
specified employees are limited to common law employees, and do not 
include other individuals. Section 409A(a)(2)(B) defines a specified 
employee as a key employee as defined in section 416(i) (without regard 
to section 416(i)(5)). Accordingly, where an individual is treated as a 
key employee for purposes of section 416(i), that individual generally 
is a specified employee for purposes of section 409A.
    Commentators requested clarification of how the definition of 
compensation under section 415 applies for purposes of identifying the 
key employees that may ultimately be specified employees. The final 
regulations clarify that the general definition of compensation under 
Sec.  1.415(c)-2(a), applied as if the service recipient were not using 
any safe harbor provided in Sec.  1.415(c)-2(d), any of the special 
timing rules provided in Sec.  1.415(c)-2(e), or any of the special 
rules provided in Sec.  1.415(c)-2(g), will be treated as the general 
definition of compensation for purposes of identifying specified 
employees. However, the final regulations also provide that a service 
recipient may use any available definition of compensation under 
section 415 and the accompanying regulations, including any available 
safe harbor and any available election under the timing rules or 
special rules, provided that the definition is applied consistently to 
all employees of the service recipient for purposes of identifying 
specified employees. A service recipient may elect to use such a 
definition of compensation regardless of whether another definition of 
compensation is being used for purposes of a qualified plan sponsored 
by the service recipient. However, once a list of specified employees 
has become effective, the service recipient cannot change the 
definition of compensation for purposes of identifying specified 
employees for the period with respect to which such list is effective. 
For a discussion of the methods for making an election regarding the 
definition of compensation, see section VII.C.4.e of this preamble.
    Commentators requested clarification of the treatment of the 
compensation of certain nonresident alien employees. As discussed in 
the preceding paragraph, for purposes of identifying key employees, the 
general definition of compensation under Sec.  1.415(c)-2(a) applies. A 
service recipient may elect to apply the rule of Sec.  1.415-
2(g)(5)(ii) and not treat as compensation certain compensation 
excludible from an employee's gross income on account of the location 
of the services or the identity of the employer that is not effectively 
connected with the conduct of a trade or business within the United 
States. If no such election is made, the provisions of Sec.  1.415(c)-
2(g)(5)(i) would apply, requiring the treatment as compensation of 
certain compensation excludible from an employee's gross income due to 
the location of the services or the identity of the service recipient.
b. Alternative Methods for Applying the Six-Month Delay Requirement
    Commentators expressed concern that an attempt to identify key 
employees could result in an underinclusive list. Rather than risk a 
violation, commentators suggested that service recipients be permitted 
to use an alternative method for determining employees subject to the 
six-month delay requirement, even where such an alternative method may 
result in an over-inclusive list. A nonqualified deferred compensation 
plan may provide that all payments upon separation from service will 
commence six months after the separation from service, regardless of 
whether the service provider is a specified employee. In addition, the 
final regulations provide that a plan may use an alternative method 
identifying the service providers whose distributions will be subject 
to a six-month delay, provided that the alternative method is 
reasonably designed to include all specified employees, the alternative 
method is an objectively determinable standard providing no direct or 
indirect election to any service provider regarding the application of 
the rule, and the alternative method results in no more than 200 
service providers being identified in the class as of any date. Use of 
such an alternative method to delay a payment in accordance with the 
rules governing the delay of payments to a specified employee will not 
be treated as a change in the time and form of payment for purposes of 
the subsequent deferral rules even if the service provider is not a 
specified employee when the payment is delayed. However, if the list 
fails to include any individual who is a specified employee and that 
individual has a right to a payment of deferred compensation upon a 
separation from service without the required six-month delay, the plan 
providing such right to such individual will not be in compliance with 
section

[[Page 19262]]

409A. For a discussion of the method of initiating an alternative 
method designation, see section VII.C.4.e of this preamble.
c. Specified Employee Effective Date Issues
    Under the proposed regulations, the employees identified as of an 
identification date would become specified employees effective as of 
the first day of the fourth month following the identification date. 
Commentators stated that service recipients who could compile the list 
of specified employees more quickly should be permitted to make the 
list effective at an earlier date. The final regulations provide that 
the first day of the fourth month will be the specified employee 
effective date if the service recipient does not specify another date. 
However, the final regulations permit a service recipient to specify a 
specified employee effective date following the specified employee 
identification date upon which the new list of specified employees will 
become effective, provided that the specified employee effective date 
may not be later than the first day of the fourth month following the 
specified employee identification date. For example, an employer that 
designates December 31 as a specified employee identification date for 
purposes of identifying key employees for purposes of the six-month 
delay rule, may specify any subsequent date on or before the following 
April 1 as the first date of the 12-month period during which such list 
of key employees will be treated as specified employees. To prevent 
manipulation, any change to the specified employee effective date may 
not become applicable until 12 months following the change in such 
specified employee effective date.
    The final regulations also clarify that the six-month delay 
requirement applies only where the service provider is a specified 
employee as of the date of separation from service, and does not become 
applicable if the service provider is not a specified employee as of 
the date of separation from service even if the service provider 
subsequently would have become a specified employee if the separation 
had not occurred.
d. Corporate Transactions
    In response to comments, the final regulations significantly alter 
the proposed rules governing the identification of specified employees 
following a corporate transaction, such as a merger or spin-off. 
Commentators requested clarification of the determination of the next 
applicable specified employee identification date following the 
corporate transaction. In addition, commentators generally objected to 
any rule that resulted in the treatment of more than 50 employees as 
specified employees due to a corporate transaction (in addition to 1-
percent and 5-percent owners treated as specified employees). The final 
regulations generally permit service recipients to avoid this result, 
but also permit service recipients to simply combine the pre-
transaction separate lists of specified employees where it is 
determined that such treatment would be administratively less 
burdensome. Service recipients can determine whether to combine such 
lists on a case-by-case basis, if there are multiple transactions 
during the same year.
    With respect to mergers and acquisitions, the final regulations 
address combinations of two public corporations, and combinations of a 
public and a closely-held corporation. For purposes of the discussion 
of the rules regarding the treatment of the identification of specified 
employees following such a transaction, references to specified 
employees include specified employees determined under any permissible 
method that the entities participating in the transaction used 
immediately before the transaction. Where two public corporations merge 
and become one public corporation, or a public corporation becomes a 
subsidiary of another public corporation, the final regulations provide 
that the resulting service recipient's next specified employee 
identification date and the first specified employee effective date 
following the transaction is the specified employee identification date 
and specified employee effective date that the acquiring service 
recipient would have been required to use absent the merger. For the 
period after the date of the transaction and before the next specified 
employee effective date, the specified employee list of the resulting 
service recipient consists of the 50 most highly compensated service 
providers appearing on the combined lists of the two service 
recipients' specified employees in effect as of the date of the 
transaction, ranking such specified employees in order of the amount of 
compensation used to determine each specified employees' status as a 
specified employee, plus any 1-percent and 5-percent owners not 
otherwise included who would be treated as specified employees. 
Alternatively, however, the resulting service recipient may use any 
other reasonable method to determine its specified employees 
immediately after the transaction, provided that such method is adopted 
not later than 90 days after the merger and applied prospectively from 
the date of adoption. For a discussion of the procedures for adopting 
such a method, see section VII.C.4.e of this preamble.
    Where a public corporation and a private corporation merge and 
become a public corporation, or where a private corporation becomes a 
subsidiary of a public corporation, the resulting service recipient's 
next specified employee identification date and specified employee 
effective date following the transaction will be the specified employee 
identification date and specified employee effective date that the pre-
transaction public corporation would have been required to use absent 
such transaction. For the time period after the transaction and before 
the next specified employee effective date, the specified employees of 
the pre-transaction public service recipient immediately before the 
transaction will continue to be the specified employees of the 
resulting service recipient, and service providers of the pre-merger 
private service recipient will not become specified employees until the 
next specified employee effective date. Consequently, the nonqualified 
deferred compensation plans in which service providers of the formerly 
private service recipient participate will not be required to contain a 
plan term delaying a payment upon separation from service of such 
service providers, or to delay such a payment, until the next specified 
employee effective date.
    The final regulations also address spin-off transactions. Where as 
part of a corporate transaction, a public service recipient becomes two 
separate public service recipients, the final regulations provide that 
the next specified employee identification date and specified employee 
effective date of each of the post-transaction service recipients is 
the specified employee identification date and specified employee 
effective date that the pre-transaction service recipient would have 
been required to use absent such transaction. For the period after the 
date of the transaction and before the next specified employee 
effective date, the specified employees of the pre-transaction service 
recipient immediately before the transaction continue to be the 
specified employees of the post-transaction service recipients.
    The final regulations provide guidance on initial public offerings 
and other corporate transactions where all or part of a private service 
recipient becomes one or more public service

[[Page 19263]]

recipients. In that case, except as discussed in this paragraph, each 
post-transaction public service recipient will have a December 31 
specified employee identification date and an April 1 specified 
employee date. Alternatively, the new public service recipient may 
establish a different specified employee identification date and 
specified employee effective date, provided that the specified employee 
identification date and specified employee effective date must be 
established on or before the date of the initial public offering or 
other corporate transaction.
    For the period between the date of the initial public offering or 
other corporate transaction and the first specified employee effective 
date, the list of specified employees of each post-transaction public 
service recipient is comprised of the service providers that at the 
time of the corporate transaction or public offering would have been 
classified as specified employees of the former private service 
recipient, had such service recipient adopted the same specified 
employee identification date and specified employee effective date as 
selected by such post-transaction public service recipient, and had 
such former private service recipient been a public service recipient 
as of such specified employee identification date.
e. Alternatives for the Identification of Specified Employees
    As discussed in this preamble, the final regulations provide 
certain default definitions for purposes of identifying specified 
employees, where the service recipient has not adopted another 
definition. These default rules include the following provisions: the 
specified employee identification date is December 31; the specified 
employee effective date is April 1; the general definition of 
compensation under Sec.  1.415(c)-2(a) will apply (without giving 
effect to any use of the special timing rules under Sec.  1.415(c)-2(e) 
or of a safe harbor definition of compensation under Sec.  1.415(c)-
2(d)); and certain rules regarding the identification of specified 
employees after a merger of public service recipients or an initial 
public offering or other transaction involving a formerly nonpublic 
service recipient becoming a public service recipient will apply.
    Alternatively, the final regulations also provide that the service 
recipient may use other permissible rules and definitions, provided 
that such alternatives become effective only in accordance with the 
rules and deadlines set forth in the final regulations. In addition, 
the final regulations permit a service recipient to use an alternative 
method for purposes of identifying specified employees, with certain 
limitations, and to make an election under Sec.  1.415(c)-2(g)(5)(i) 
regarding the treatment as compensation of certain compensation 
excludible from an employee's gross income due to the location of the 
services or the identity of the employer. For purposes of these rules, 
a service recipient may use one of these alternatives when all 
necessary corporate action has been taken to make such alternative 
binding for purposes of all affected deferred compensation plans in 
which service providers of the service recipient participate. 
Accordingly, as a practical matter, the service recipient may find it 
expedient either to specify the definition of specified employee in all 
of its nonqualified deferred compensation plans or to retain the 
discretion in all such plans to make such determinations and take any 
necessary corporate action in accordance with each such plan.
f. Application of the Six-Month Delay Rule
    The final regulations reflect the statutory language that a plan 
may provide that a payment will be made, notwithstanding the six-month 
delay, upon the service provider's death. A commentator requested 
similar treatment for the occurrence of a disability, unforeseeable 
emergency, or change in control event during the six months following 
the separation from service. The Treasury Department and the IRS do not 
believe that the statute permits such flexibility, but rather 
categorically prohibits any distribution due to a separation from 
service during the six months following the separation from service 
except where the service provider dies. Accordingly, where a payment on 
account of a separation from service has been delayed because the 
service provider is a specified employee, the payment may not be 
accelerated due to disability, a change in control event, or an 
unforeseeable emergency. However, where a payment is made to a 
specified employee on account of disability, a change in control event, 
or an unforeseeable emergency (as defined for purposes of section 
409A), the payment need not be delayed merely because the specified 
employee separates from service after incurring the disability or 
unforeseeable emergency, or after the change in control event.
    Commentators further requested that various types of periodic 
benefit payments be excluded from the six-month delay requirement, even 
if such payments constitute a payment of deferred compensation. 
Commentators argued that the requirement to delay such payments would 
be excessively burdensome and impracticable, given the nature and 
amount of benefits generally available under such arrangements. The 
Treasury Department and the IRS are not convinced that periodic payment 
or reimbursement plans should be excluded from the six-month delay 
rule; otherwise, deferred compensation could simply be converted to 
such programs to avoid the delay. However, as clarified in the final 
regulations, certain plans that provide for reimbursements or in-kind 
benefits during the six months following a separation from service will 
not be treated as nonqualified deferred compensation plans under the 
rules governing separation pay plans. See section III.J.6 of this 
preamble.
    The final regulations also provide that the required delay of a 
payment to a specified employee upon a separation of service is not 
violated where the payment is made before the end of the six-month 
period due to an acceleration of a payment in compliance with the 
provisions of the regulations permitting accelerated distributions due 
to a domestic relations order, to satisfy a Federal, state, local, or 
foreign ethics law, or to pay certain employment taxes (see section 
VIII of this preamble).
5. Different Times and Forms of Payment on Separation From Service 
Under Specified Circumstances
    The final regulations continue to provide that a time and form of 
payment must be specified with respect to each permissible payment 
event. Under the proposed regulations, a second time and form of 
payment could be established for a payment due to a permissible payment 
event where the distinction was based upon the event occurring before 
or after a certain date, such as the service provider reaching a 
certain age. Commentators requested that different times and forms of 
payment be permitted if based upon different types of separations from 
service. The final regulations generally provide that the time and form 
of payment upon a separation from service may vary depending upon 
either or both of the following: (1) Whether the separation from 
service occurs during a limited period of time not to exceed two years 
following a change in control event as defined for purposes of section 
409A; or (2) whether the separation from service occurs before or after 
a specified date (for example, the attainment of a specified age), or 
before or after a combination of a specified date and a specified 
period of service determined under a predetermined objective

[[Page 19264]]

formula or pursuant to the method for crediting service under a 
qualified plan sponsored by the service recipient. The addition or 
deletion of such a different time and form of payment applicable to an 
existing deferral is subject to the subsequent deferral election rules 
and the anti-acceleration rules.
D. Disability
    The final regulations generally adopt the definition of disability 
and other provisions related to the payment of an amount upon a service 
provider becoming disabled contained in the proposed regulations, 
subject to the modifications described in this preamble. For this 
purpose, a participant is disabled if the participant 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 expected to last for a continuous period of 
not less than 12 months, or 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 participant's employer. The determination of whether a service 
provider is disabled may be made by any person, including the 
administrator of a disability insurance program, and the plan need not 
specify who will make the determination. However, the plan will be 
treated as complying with section 409A only if the disability required 
for a payment complies with the definition of disability under the 
regulations, and a payment due to a disability will be deemed to comply 
with section 409A if the service provider has actually suffered a 
qualifying disability. The final regulations also provide that a plan 
may provide that a service provider will be deemed disabled if the 
service provider is determined to be totally disabled by the Social 
Security Administration or the Railroad Retirement Board.
    Commentators raised questions concerning the ability to pay upon 
the occurrence of a disability that does not qualify as a disability 
under the statute, where as a result of the disability the service 
provider has a separation from service. Such a payment would not 
constitute a payment due to a disability that complied with section 
409A. However, if the plan provided for a payment due to the separation 
from service, a payment would constitute a payment due to a separation 
from service regardless of whether the separation from service resulted 
from such a disability and regardless of whether the service provider's 
right to receive such payment was conditioned upon the service provider 
being disabled under such disability definition. For a discussion of 
the ability to provide for different times and forms of payment due to 
different types of separations from service, including separations from 
service due to certain disabilities, see section VII.C.4 of this 
preamble.
E. Death
    Most of the comments with respect to amounts that are payable due 
to the death of a service provider related to whether a beneficiary of 
the service provider could be given the opportunity to elect a time and 
form of payment under a plan without violating section 409A. The final 
regulations clarify that elections with respect to the time and form of 
payment to a beneficiary are subject to the general rules governing 
subsequent deferrals and accelerated payments, including elections by 
either the service provider or the beneficiary (with an exception for 
amounts payable under a domestic relations order). However, a change in 
a beneficiary will not be treated as a change in the time and form of 
payment, if the change in the time of payment stems solely from the 
different life expectancy of the new beneficiary, such as in the case 
of a joint and survivor annuity. Commentators requested that 
beneficiaries be permitted a limited period of time in which to change 
the time and form of payment without being subject to the subsequent 
deferral and anti-acceleration provisions. The Treasury Department and 
the IRS do not believe that the statutory language supports this type 
of late deferral election or payment acceleration. Accordingly, these 
suggestions are not adopted in the final regulations.
F. Change in Ownership or Effective Control of a Corporation
    The final regulations generally adopt the provisions contained in 
the proposed regulations with respect to the definition of a change in 
control event, as well as certain special rules with respect to 
payments upon a change in control event, subject to the modifications 
described in this preamble.
    One commentator requested that the threshold for a change in the 
effective control of a corporation be lowered from 35 percent to 20 
percent, especially for a public corporation. The legislative history 
of section 409A indicates that the definition of a change in control 
event is to be based upon, but more restrictive than, the definition 
provided in section 280G. H.R. Conf. Rep. No. 108-755, at 730 (2004). 
Given that Sec.  1.280G-1, Q&A-28(a)(1) provides for a 20 percent 
standard, the adoption of that standard is not appropriate in light of 
the legislative history. However, the final regulations lower the 
threshold to 30 percent.
    One commentator requested guidance with respect to the application 
of the change in control provisions to non-stock, non-profit 
corporations. The Treasury Department and the IRS are considering 
whether such guidance is appropriate, and if so what types of changes 
could be treated as analogous to a change in control event involving a 
stock corporation. Until further guidance, a non-stock, non-profit 
corporation may apply the change in effective control provisions in 
Sec.  1.409A-3(i)(5) (relating to a change in the composition of the 
board of directors) by analogy to changes in the composition of its 
board of directors, trustees, or other governing body.
    The final regulations continue to provide that in the case of a 
payment on account of certain change in control events (a change in 
ownership of a corporation or a change in the ownership of a 
substantial portion of a corporation's assets), compensation payable 
pursuant to the service recipient's purchase of service recipient stock 
or a service recipient stock right held by a service provider, or 
payment of amounts of deferred compensation calculated by reference to 
the value of service recipient stock, generally may be treated as 
complying with the requirements of section 409A if paid under the terms 
and conditions that govern the payments to shareholders or the service 
recipient in connection with the change in control event. The final 
regulations continue to require that such amounts be paid no later than 
five years after the change in control event. However, the final 
regulations also provide that where such compensation is made subject 
to a condition on payment that constitutes a substantial risk of 
forfeiture under section 409A (without regard to the prohibition on 
additions or extensions of forfeiture conditions), and such 
compensation is payable under the same terms and conditions as apply to 
payments made to shareholders generally with respect to stock of the 
service recipient, or to the service recipient itself, pursuant to the 
change in control event, for purposes of determining whether such 
compensation is a short-term deferral the requirements of the short-
term

[[Page 19265]]

deferral rule are applied as if the legally binding right to such 
compensation arose on the date that it became subject to the 
substantial risk of forfeiture. The regulations also provide rules 
under which certain pre-existing forfeiture conditions may be extended 
or modified in connection with such a change in control event.
G. Unforeseeable Emergency
    The final regulations apply the provisions set forth in section 
409A(a)(2)(B)(ii) regarding payments upon an unforeseeable emergency. 
The final regulations provide that 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 plan. 
The final regulations clarify that for these purposes, the availability 
of payments due to the unforeseeable emergency under any other 
nonqualified deferred compensation plan as defined for purposes of 
section 409A, including plans that would be nonqualified deferred 
compensation plans for purposes of section 409A except due to the 
effective date of the statute, or under any qualified plan (including 
any assets available by obtaining a loan under a qualified plan), need 
not be considered in determining whether an emergency is or may be 
relieved through other means. Accordingly, a payment due to an 
unforeseeable emergency may be made pursuant to a nonqualified deferred 
compensation plan that is subject to section 409A even though the 
financial need could be satisfied through an available distribution or 
loan from a qualified plan, from a grandfathered nonqualified deferred 
compensation plan, or from another nonqualified deferred compensation 
plan that is subject to section 409A.
    Section 826 of the Pension Protection Act of 2006, Public Law 109-
280 (120 Stat. 780) modified the rules governing payments upon an 
unforeseeable emergency. Specifically, section 826 requires that the 
Treasury Department and the IRS modify the rules for determining 
whether a service provider has had an unforeseeable emergency for 
purposes of section 409A(a)(2)(B)(ii) to provide that if an event would 
constitute a hardship under the plan if it occurred with respect to the 
service provider's spouse or dependent, such event will, to the extent 
permitted under a plan, constitute a hardship if it occurs with respect 
to a person who is a beneficiary under the plan with respect to the 
service provider. The final regulations reflect this modification.
H. Multiple Payment Events
    The final regulations provide that a plan may provide for a payment 
based upon the earlier of, or the later of, a series of events, 
provided that each payment event would otherwise satisfy the 
requirements of section 409A. The final regulations also provide that 
for purposes of the subsequent deferral and acceleration rules, each 
payment event will be viewed separately for purposes of analyzing the 
effect of a change in the time and form of payment. For a discussion of 
the effect of the addition or deletion of a permissible payment event 
from such a list, see section IX.C of this preamble.
I. Delay in Payment by the Service Recipient
    Commentators requested that a service recipient be permitted to 
delay a payment, where the delay is due to bona fide business concerns 
such as cash flow considerations. Where a payment is delayed due to the 
operation of a pre-specified objective, nondiscretionary formula 
related to the business performance of the service recipient, the 
payment generally may be delayed (for example, where payments in any 
given year are limited to a certain percentage of cash flow) provided 
that the time for later payment is governed by the objective, 
nondiscretionary formula. See section VII.B.3 of this preamble. In 
addition, the final regulations provide that if at the time of a 
specified payment date the making of the payment would jeopardize the 
ability of the service recipient to continue as a going concern, the 
payment will be treated as made upon the specified payment date if the 
payment is made during the first taxable year of the service provider 
in which the making of the payment would not have such effect. This 
provision is not required to be explicitly provided in the plan.
    Because this provision permits the service recipient to delay any 
payment the making of which would jeopardize the ability of the service 
recipient to continue as a going concern, the provision in the proposed 
regulations permitting a delay in payment required to avoid a violation 
of a loan covenant or similar contractual obligation, where such 
violation would cause material harm to the service recipient, has not 
been adopted in the final regulations. Rather, where the payment would 
result in a violation of a loan covenant or similar contractual 
obligation, and the violation would jeopardize the ability of the 
service recipient to continue as a going concern, the payment can be 
delayed under the general provision.
    The final regulations adopt the provision of the proposed 
regulations that permits a delay in payment necessary to avoid the 
application of the deduction limitation under section 162(m), subject 
to the following modifications. First, a plan is not required to 
provide explicitly for such a delay. However, the final regulations 
require that where any payment in a service recipient's taxable year is 
delayed in accordance with this provision, then all payments that could 
be delayed in accordance with this provision must be delayed (though 
some payments may be delayed until after separation from service and 
others until the earliest taxable year in which the deduction 
limitation no longer applies). Second, except as provided in the next 
sentence, the regulations provide that the payment must be made either 
during the service provider's first taxable year in which the service 
recipient reasonably anticipates, or reasonably should anticipate, that 
if the service recipient makes such payment during such year such 
payment will not fail to be deductible because of section 162(m) or, if 
later, during the period beginning on the day the service provider 
separates from service and ending on the later of the last day of the 
service provider's taxable year in which the separation from service 
occurs or the 15th day of the third month following the separation from 
service. Finally, the final regulations provide that where the payment 
has been delayed until the service provider's separation from service, 
the six-month delay requirement for specified employees may apply. 
Although commentators argued that the six-month delay rule should not 
apply because the original payment would not have been subject to the 
rule, this same argument could be made with respect to any deferral 
election to have current compensation paid instead at a separation from 
service, and accordingly is not adopted in the final regulations.
J. Disputed Payments and Refusals to Pay
    The final regulations adopt the provisions in the proposed 
regulations with respect to disputed payments and refusals to pay, 
subject to certain modifications. If a payment is not made due to a 
service recipient's refusal to pay an amount, the amount generally will 
be treated as paid in a timely

[[Page 19266]]

manner if the service provider makes reasonable, good faith efforts to 
collect the payment. This provision is intended to address not only 
intentional refusals to pay, but also inadvertent delays (but, in 
either case, only if there is no collusion between the service provider 
and service recipient). For example, where through oversight a service 
recipient fails to make a payment on the required payment date, the 
payment will be treated as made on the specified date if the service 
provider makes reasonable, good faith efforts to collect the payment, 
generally through providing timely notice to the service recipient that 
the payment is due and unpaid. For this purpose, efforts to collect the 
payment will be presumed not to be reasonable, good faith efforts if 
notice is not given to the service recipient within 90 days of the 
latest date upon which the payment could have been timely made in 
accordance with the terms of the plan and the regulations and, if not 
paid, further measures to enforce the payment are not taken within 180 
days after such date. For a discussion of payments that are accelerated 
due to a settlement of a bona fide dispute as to the service provider's 
right to the payment, see section VIII.G of this preamble.
K. Back-to-Back Arrangements
    The proposed regulations addressed certain arrangements under which 
an entity (the intermediate service recipient) receives services from a 
service provider and provides services to a client (the ultimate 
service recipient), and the time the intermediate service recipient is 
entitled to receive a payment for services rendered to the ultimate 
service recipient is controlled by the date on which the intermediate 
service recipient is obligated to make a payment of deferred 
compensation to the service provider. For example, assume an 
intermediate service recipient provides investment management services 
for a group of investors. Pursuant to a nonqualified deferred 
compensation plan, the intermediate service recipient has agreed to pay 
its employee a sum certain when the employee terminates employment. 
Under the intermediate service recipient's agreement with the investor 
group, the investors will pay the same sum certain to the intermediate 
service recipient when the employee terminates employment. The proposed 
regulations referred to these types of arrangements as back-to-back 
arrangements.
    The final regulations adopt the proposed provisions that addressed 
back-to-back nonqualified deferred compensation arrangements, subject 
to the modifications described in this section. The final regulations 
clarify that the rules addressing back-to-back arrangements apply 
regardless of whether the arrangement between the service provider and 
the intermediate service recipient is actually subject to section 409A, 
as long as each arrangement that is part of the overall back-to-back 
scheme complies with the requirements of section 409A without regard to 
whether such arrangement is actually subject to section 409A. 
Accordingly, the accommodations afforded to back-to-back arrangements 
are only applicable to the extent that each arrangement satisfies the 
requirements of section 409A as if those requirements applied to each 
such arrangement (modified in accordance with the back-to-back rules).
    Commentators also requested that, with respect to taxpayers 
providing management services that are not eligible for the exception 
from coverage for independent contractors with multiple unrelated 
customers, the exception from the general payment timing rules 
permitting certain back-to-back arrangements be expanded to include not 
only arrangements where the payment from an ultimate service recipient 
to the intermediate service recipient is based upon the timing of a 
required payment under a section 409A compliant plan from the 
intermediate service recipient to a service provider (a forward back-
to-back arrangement), but also where the payment to the service 
provider is based upon a required payment under a section 409A 
compliant arrangement from the ultimate service recipient to the 
intermediate service recipient (a reverse back-to-back arrangement). 
For example, a service recipient that provides investment management 
services to an investor group may have an arrangement whereby the 
investors are required to pay all amounts due to the investment manager 
service recipient if the investor group terminates the client 
relationship, and the investment manager service recipient in turn has 
an agreement with an employee to pay the employee a certain percentage 
of the amount the investor group pays to the investment manager service 
recipient, following termination of the client relationship. The final 
regulations do not provide an exception from the requirements of 
section 409A for reverse back-to-back arrangements, but the Treasury 
Department and the IRS will continue to study the matter.

VIII. Prohibition of Accelerated Payments

A. In General
    Section 409A(a)(3) provides that a plan may not permit the 
acceleration of the time or schedule of any payment under the plan, 
except as provided in regulations by the Secretary. The final 
regulations retain the provisions in the proposed regulations relating 
to accelerated payments, subject to the modifications described in this 
preamble.
    The final regulations generally provide that a payment of an amount 
as a substitute for a payment of deferred compensation will be treated 
as a payment of the deferred compensation, including for purposes of 
the prohibition on accelerated payments. Where a payment of an amount 
results in an actual or potential reduction of, or an actual or 
potential current or future offset to, an amount of deferred 
compensation, or the service provider receives a loan the repayment of 
which is secured by or may be accomplished through an offset of a 
nonqualified deferred compensation benefit, then the payment or loan is 
a substitute for the deferred compensation and is treated as a payment 
of the deferred compensation itself. If a service provider's rights to 
deferred compensation are subject to anticipation, alienation, sale, 
transfer, assignment, pledge, encumbrance, attachment, or garnishment 
by creditors of the service provider or the service provider's 
beneficiary, such amounts are treated as having been paid to the 
service provider.
    The receipt of a payment of compensation, or right to a payment of 
compensation, proximate to the purported forfeiture or voluntary 
relinquishment of a right to deferred compensation generally is treated 
as a substituted payment for the payment of the deferred compensation. 
For example, where the right to an amount of deferred compensation is 
purportedly relinquished or forfeited, and concurrently or subsequently 
the service provider receives a current bonus payment, the bonus 
payment will be presumed to be a substitute payment for the amount of 
deferred compensation. The presumption is rebuttable by a showing that 
the compensation paid would have been paid regardless of the 
relinquishment or forfeiture of the right to the deferred compensation. 
For a discussion of the application of this provision to amounts 
forfeitable upon a separation from service, see section III.J.1 of this 
preamble.
    A plan may not provide discretion to a service provider regarding 
whether a

[[Page 19267]]

payment will be accelerated under one of the rules permitting the 
acceleration of payments under specified circumstances (for example, to 
comply with a domestic relations order), including through the 
provision of an election. However, where a plan provides a service 
recipient discretion to accelerate payments under one of the rules 
permitting the acceleration of a payment, the failure to accelerate 
such a payment will not constitute a subsequent deferral election.
B. Plan Termination and Liquidation
    The proposed regulations contained provisions permitting a service 
recipient to terminate and liquidate a nonqualified deferred 
compensation plan, including when the service recipient has declared 
bankruptcy, when the service recipient has participated in certain 
change in control events, or at the discretion of the service 
recipient, all subject to certain restrictions and limitations. 
Commentators expressed concern over the restrictions and limitations. 
Some comments reflected confusion as to the meaning of these terms in 
the context of section 409A. The termination and liquidation of a 
nonqualified deferred compensation plan involves both the amendment of 
the plan to cease deferrals under the plan and provide for payment of 
all benefits accrued under the plan, and the accelerated payment of 
benefits accrued under the plan.
    Several comments suggested that the final regulations expand the 
circumstances under which a service recipient may terminate and 
liquidate a nonqualified deferred compensation plan. Generally these 
comments requested discretion in case of a change in business 
conditions or circumstances, resulting in the service recipient's 
desire to terminate and liquidate the plan. The final regulations 
expand the circumstances under which a sale of assets of a corporation 
will result in a separation from service. See section VII.C.2.f of this 
preamble. In addition, the final regulations continue to allow the 
service recipient to terminate and liquidate a plan during a defined 
period following a change in control event. Outside of these particular 
business events, the comments failed to provide an objective standard 
or category of changes in business conditions or circumstances that 
would provide a safeguard against the use of plan termination and 
liquidation provisions to circumvent the prohibition on accelerations. 
Accordingly, the final regulations do not expand the ability of a 
service recipient to exercise its discretion to terminate and liquidate 
a deferred compensation plan. However, the period of time during which 
a service recipient may not commence a new plan after terminating and 
liquidating a nonqualified deferred compensation plan has been 
shortened from five years to three years. Also, the final regulations 
provide that a discretionary plan termination and liquidation will not 
qualify for this exception if it is proximate to a downturn in the 
financial health of the service recipient.
    The final regulations clarify the rules under which a deferred 
compensation plan may be terminated and liquidated upon a change in 
control event. Under the final regulations, the service recipient must, 
within the 30 days preceding or the 12 months following the change in 
control event, take all necessary action to terminate and liquidate the 
plan and such action must be irrevocable. In addition, for the plan to 
be treated as terminated and liquidated, all other arrangements that 
would be classified with the plan as a single plan if the same service 
provider participated in the plan and all the other arrangements must 
be terminated and liquidated, so that all service providers who are 
participants in the plan and all such other arrangements required to be 
terminated and liquidated must receive all amounts of compensation 
deferred under the terminated and liquidated plan and other 
arrangements within 12 months of the date the service recipient takes 
such irrevocable action to terminate and liquidate the arrangements. 
For purposes of the rule, the entities comprising the service recipient 
are determined immediately following the change in control event, and 
the rule only applies with respect to service providers for whom a 
change in control has occurred. For example, where the change in 
control event consists of a sale of a subsidiary corporation such that 
the subsidiary corporation is no longer treated as a single service 
recipient with the (former) parent corporation, the requirement to 
terminate and liquidate substantially similar arrangements applies only 
to the purchaser service recipient group of corporations that now owns 
the subsidiary corporation. In addition, the rule would apply only to 
the service providers that had experienced a change in control, 
generally consisting only of the service providers of the subsidiary 
corporation. Where the change in control event consists of an asset 
purchase, the applicable service recipient with discretion to terminate 
and liquidate the plan is deemed to be the entity retaining the 
deferred compensation liability after the transaction.
    Some commentators asked whether the plan termination and 
liquidation rules apply if a plan is terminated and liquidated when the 
service provider has no vested right to a payment, and all payments are 
forfeited. Where the service recipient retained the unfettered 
discretion to terminate such a plan without paying benefits, the 
service provider may not have obtained a legally binding right to a 
payment. In addition, if a service provider forfeits benefits under a 
nonqualified deferred compensation plan in exchange for other taxable 
benefits, those benefits may be treated as a payment of amounts under 
the nonqualified deferred compensation plan.
C. Conflicts of Interest and Ethics Rules
    The proposed regulations contained a special accelerated payment 
rule to permit accelerated payments required to be made by a 
certificate of divestiture. Notice 2006-64, 2006-29 IRB 88, see Sec.  
601.601(d)(2), expanded this exception to address situations in which a 
letter is received from the Office of Government Ethics that 
divestiture of the deferred compensation is required. Several 
commentators requested an expansion of these rules.
    The final regulations provide that a payment may be accelerated 
where necessary for a Federal officer or employee in the executive 
branch to comply with an ethics agreement with the Federal government. 
The final regulations also provide that a payment may be accelerated 
where reasonably necessary to avoid the violation of a Federal, state, 
local, or foreign conflict of interest law or ethics law (including 
where such payment is reasonably necessary to permit the service 
provider to participate in activities in the normal course of his or 
her position in which the service provider would otherwise not be able 
to participate under an applicable law). For this purpose, a payment 
will be reasonably necessary to avoid such a violation if the making of 
the payment is a necessary part of a combination of actions resulting 
in compliance with the applicable law. A payment may be considered 
necessary to avoid such a violation even though actions other than 
making the payment could also result in compliance with the applicable 
law. For example, as requested by several commentators, this provision 
would provide a public accounting firm the ability to accelerate 
payments where reasonably necessary to satisfy conflict of interest 
rules prescribed by the Securities and Exchange Commission. This 
paragraph

[[Page 19268]]

is intended to address payments to service providers, as well as 
payments to a spouse or minor children where such payments are 
reasonably necessary to comply with the applicable law. For this 
purpose, foreign law is considered to be applicable only to foreign 
earned income from sources within the foreign country that promulgated 
such law.
D. State and Local Taxes, RRTA Tax and Foreign Taxes
    Commentators stated that certain state and local jurisdictions tax 
nonqualified deferred compensation plans under a different set of rules 
than the Federal income tax rules, typically by reference to the rules 
applicable to FICA taxes. Commentators also requested that 
accelerations be permitted to cover applicable RRTA taxes. Finally, 
commentators requested that accelerated payments be permitted to 
account for the tax laws of foreign jurisdictions that may not be 
consistent with the Federal income tax rules. The final regulations 
adopt the suggestions with respect to state and local taxes, RRTA 
taxes, and foreign taxes.
E. Minimum Distributions Under Section 280H(d)
    One commentator suggested that acceleration be permitted to allow a 
personal service corporation to make minimum distributions to avoid 
taxation under section 280H(d). The Treasury Department and the IRS 
believe that such a provision would give taxpayers excessive control 
over the payment of deferred amounts that would be inconsistent with 
the purposes of section 409A. Therefore, this suggestion was not 
adopted.
F. Top Hat Plan Rules
    Some commentators requested that the final regulations permit a 
service recipient to accelerate payments or cancel deferral elections 
with respect to a service provider who is not part of a select group of 
management or highly compensated employees for purposes of the 
exclusion from coverage under certain provisions of the Employee 
Retirement Income Security Act of 1974 relating to top hat plans. See, 
for example, 29 U.S.C. 1051(2). Given the current lack of clarity with 
respect to the scope of coverage of the top hat plan rules, and the 
actions required when a plan participant no longer satisfies the 
requirement to qualify for the top hat plan rules, the Treasury 
Department and the IRS are not confident that an exception to the anti-
acceleration provisions based upon these rules is feasible. 
Accordingly, the final regulations do not adopt this suggestion.
G. Settlements of Bona Fide Disputes Regarding the Right to a Payment
    Commentators requested relief for certain payments made as a 
settlement of a dispute as to a service provider's right to a deferred 
amount. For example, assume that a plan provides for a payment of 
deferred compensation upon a termination of an employee's employment 
other than for cause and the employee and employer have a bona fide 
dispute as to whether the employee was terminated for cause, and thus 
whether the service provider is entitled to any payment under the plan. 
The final regulations provide that payments may be accelerated, 
including acceleration to payment as a lump sum, where the right to 
such payments arises as part of a settlement between the service 
provider and the service recipient of a bona fide dispute as to the 
service provider's right to the deferred amount. The provision applies 
only to a deferred amount, the right to which is the subject of an 
arm's length settlement of a bona fide dispute between the service 
provider and the service recipient, and only to the portion of the 
deferred amount that is the subject of the bona fide dispute. The 
provision does not apply to disputes that relate only to when (and not 
whether) a payment is due. Whether a payment qualifies for the 
exception is based on the particular facts and circumstances. A payment 
will be presumed not to meet this exception unless the payment is 
subject to a substantial reduction in the value of the payment made in 
relation to the amount that would have been payable had there been no 
dispute as to the service provider's right to the payment. For this 
purpose, a reduction that is less than 25 percent of the present value 
of the deferred amount in dispute generally is not a substantial 
reduction. In addition, a payment will be presumed not to meet this 
exception if the payment is made proximate to a downturn in the 
financial health of the service recipient.
H. Cashout Rules
    Commentators requested various modifications to the cashout rules 
generally expanding the conditions under which a service recipient may 
exercise discretion to cash out a service provider's entire amount 
deferred under a plan. The final regulations generally provide that a 
service recipient may exercise such discretion at any time that a 
service provider's amount deferred under the plan is less than the 
applicable dollar amount under section 402(g)(1)(B) for that calendar 
year. For this purpose, the plan aggregation rules apply, so a service 
recipient may not use this rule to cash out an amount under one 
arrangement but not another arrangement where the two arrangements 
would be treated as one plan. The final regulations, unlike the 
proposed regulations, do not require that a service provider have 
separated from service for the service recipient to cash out the amount 
deferred. In addition, the plan does not need to be amended to provide 
this discretion to the service recipient. Finally, the amount has been 
changed from $10,000 to the limit on elective deferrals under section 
402(g) to permit the amount to be adjusted for changes in the cost of 
living.
    The final regulations also provide that a plan under which amounts 
are to be paid in installments may provide for immediate payment of all 
remaining installments if the present value of the deferred amount to 
be paid in the remaining installments falls below a predetermined 
amount, and such immediate payment will not constitute an accelerated 
payment for purposes of Sec.  1.409A-3(j)(1), provided that such 
feature (including the predetermined amount) is established no later 
than the latest time at which the time and form of payment is otherwise 
required to be established, and provided further that any change in 
such feature including the predetermined amount must comply with the 
requirements for a change in the time and form of payment.
I. Other Acceleration Issues
    Commentators requested that a service recipient be permitted to 
cancel a service provider's deferral elections in two situations. 
First, commentators asked that such a cancellation be allowed when the 
service provider is transferred to a position that is not eligible to 
participate in the plan. The Treasury Department and the IRS are not 
confident that a standard can be established that would clearly 
distinguish a bona fide transfer to an ineligible position from a pro 
forma transfer designed to avoid the prohibition on accelerated 
payments, especially when the underlying plan is specific to the 
service provider, as in the case of an individual employment agreement, 
and accordingly the final regulations do not adopt this suggestion. 
Second, commentators asked that a service provider's deferral election 
be cancelled if the service provider becomes disabled. The final 
regulations permit the cancellation of the service provider's deferral 
election due to a disability, provided that for this purpose a 
disability is defined as any medically determinable physical or mental

[[Page 19269]]

impairment resulting in the service provider's inability to perform the 
duties of his or her position or any substantially similar position, 
where such impairment can be expected to result in death or can be 
expected to last for a continuous period of not less than six months.

IX. Subsequent Changes in the Time and Form of Payment

A. In General
    The final regulations clarify that the rules governing changes in 
the time and form of payment apply both to service providers and 
service recipients. Accordingly, a service provider, a service 
recipient, or both a service provider and a service recipient may have 
and exercise discretion to defer a deferred compensation payment after 
the time and form of payment have been specified, provided that such 
discretion is limited to changes that comply with the requirements of 
these regulations addressing subsequent changes in the time and form of 
payment.
B. Annuities
    Many commentators requested clarification and expansion of the 
rules that allow taxpayers to treat actuarially equivalent life 
annuities as one form of payment, thereby allowing elections among such 
annuity forms at any time before the initial annuity payment without 
regard to the rules on subsequent deferral elections. The final 
regulations clarify the circumstances under which two actuarially 
equivalent life annuities may be treated as one form of payment.
    The final regulations generally provide that certain specified 
features are ignored for purposes of determining whether a particular 
annuity is treated as a life annuity for purposes of the form of 
payment rules (but not for purposes of determining whether a life 
annuity with such a feature is actuarially equivalent to a life annuity 
without such a feature). The specified features include: (1) Term 
certain features (under which annuity payments continue for the longer 
of the life of the annuitant or a fixed period of time); (2) pop-up 
provisions (under which payments increase upon the death of the 
beneficiary or another event that eliminates the right to a survivor 
annuity); (3) cash refund features (under which payment is provided 
upon the death of the last annuitant in an amount that is not greater 
than the excess of the present value of the annuity at the annuity 
starting date over the total of payments before the death of the last 
annuitant); (4) Social Security or Railroad Retirement leveling 
features (including leveling features related to early retirement, 
survivor or disability benefits); and (5) features applying a 
permissible cost-of-living index. Accordingly, a life annuity with any 
of the specified features may be treated as a life annuity without 
regard to the fact that the features cause the annuity to fail to 
satisfy the general definition for life annuities, for example, because 
the periodic payments are not substantially equal. However, the life 
annuity with such a feature may only be treated as the same form of 
payment as a life annuity without such a feature if the two life 
annuities are actuarially equivalent (taking into account the feature) 
and have the same initial payment date.
    Commentators also raised issues concerning the availability of 
subsidized joint and survivor annuities. The final regulations provide 
that for purposes of the definition of a time and form of payment, a 
subsidized joint and survivor annuity is treated as actuarially 
equivalent to a single life annuity provided that, neither the annual 
lifetime annuity benefit nor the annual survivor benefit available 
under the joint and survivor annuity is greater than the annual 
lifetime annuity benefit available under the single life annuity. For 
example, a single life annuity providing $100 a month for the lifetime 
of the service provider may be treated as actuarially equivalent to a 
joint and survivor annuity providing up to $100 a month for the 
lifetime of the service provider and up to $100 a month to the 
surviving joint annuitant.
    Commentators asked whether the actuarial assumptions and methods 
used to determine actuarial equivalency must be applied consistently. 
The final regulations clarify that in determining whether two life 
annuities are actuarially equivalent, the same actuarial assumptions 
and methods must be used in valuing each life annuity. This requirement 
applies over the entire term of the service provider's participation in 
the plan, such that the annuities must be actuarially equivalent at all 
times for the annuity options to be treated as one time and form of 
payment. However, provided the actuarial methods and assumptions are 
reasonable, there is no requirement that consistent actuarial 
assumptions and methods be used over the term of the service provider's 
participation in the plan. Accordingly, the plan may change the 
actuarial assumptions and methods used to determine the life annuity 
payments, provided that all of the actuarial assumptions and methods 
are reasonable. In addition, there is no requirement that the actuarial 
assumptions and methods used under a nonqualified deferred compensation 
plan be the same as those used in a qualified plan sponsored by the 
service recipient.
C. Application to Multiple Payment Events
    The final regulations continue to provide that the subsequent 
deferral and anti-acceleration rules generally will apply to the 
addition or deletion of a permissible payment event. Commentators asked 
for clarification of how these rules apply.
    The Treasury Department and the IRS believe that a failure to 
provide for a payment event at death, disability or an unforeseeable 
emergency generally will result from oversight, and that the addition 
of such a provision generally would not be abusive. Accordingly, the 
final regulations provide that the addition of death, disability, or an 
unforeseeable emergency as a potentially earlier payment event is a 
permissible acceleration. This provision does not apply to the addition 
of death, disability, or an unforeseeable emergency as a potentially 
later payment event, such as through the addition of death as a payment 
event to a plan providing for a payment of deferred compensation on a 
fixed date, so that after the change the payment would be due on the 
later of the fixed date or death. Nor, for example, would it apply to 
an amendment of a plan to substitute a service provider's death as a 
new payment event, instead of a fixed payment date. In those cases, the 
rules governing subsequent deferral elections apply. In addition, the 
substitution of death as a payment event for an amount that is deferred 
compensation will not cause the plan to be treated as a death benefit 
plan not subject to section 409A, but the substitution or addition of a 
payment event other than death as a payment event in a death benefit 
plan may result in the plan being treated as providing for deferred 
compensation.
    The anti-acceleration provisions apply to the addition of a 
specified date or fixed schedule, a change in control event, or 
separation from service as a potentially earlier payment event, 
including the substitution of one of these payment events for another 
payment event. In addition, the anti-acceleration provisions apply 
where a payment event is removed from a plan term requiring payment 
upon the latest of two or more payment events. The provisions governing 
subsequent deferral elections apply to all changes in the time and form 
of payment, whether resulting from the addition, deletion or 
substitution of another payment event.

[[Page 19270]]

Commentators requested clarification of how this provision would apply 
where the events were not specified dates, such as the substitution of 
a change in control payment event for a separation from service event. 
In such a situation, to satisfy the rules governing subsequent 
deferrals, this substitution would only be permissible if the change 
were not effective for one year, and provided that the payment would 
only occur upon the later of a change in control event or at least five 
years following a separation from service.
D. Application to Domestic Relations Orders
    The final regulations provide that the rules governing changes in 
the time and form of payment do not apply to changes in the time and 
form of payment under the terms of a domestic relations order, to the 
extent the change in the time and form of payment applies to a payment 
that will be made to the alternate payee and not the service provider. 
Accordingly, for example, a domestic relations order generally may 
provide for a new time and form of payment to a spouse or former spouse 
of the service provider, or provide such spouse or former spouse 
discretion to determine the time and form of payment to such spouse or 
former spouse.

X. Application to Nonqualified Deferred Compensation Plans Linked to 
Qualified Plans and Other Arrangements

A. Plans Linked to Qualified Plans and Certain Broad-Based Foreign 
Retirement Plans
    The final regulations generally adopt the relief provided in the 
proposed regulations with respect to the election-timing and the anti-
acceleration rules for changes in the amount of benefits under a 
nonqualified deferred compensation plan that result from an election 
(or failure to elect) by a service provider, or an amendment by a 
service recipient, in respect of a subsidized or ancillary benefit 
under a qualified plan. In response to comments, this relief is 
similarly extended to certain broad-based foreign retirement plans. In 
addition, this relief is extended for benefit formulas that include a 
reduction for amounts credited to the service provider's account under 
a tax-qualified plan (which may include matching contributions) or 
certain broad-based foreign retirement plans that provide benefits 
expressed as an account balance.
    In response to comments, the final regulations also clarify that 
the linked plan relief provided for elective deferrals (including 
designated Roth contributions) and matching type contributions, each up 
to the section 402(g) dollar limit on elective deferrals, are separate, 
additive limits and are not a single, coordinated limit. In addition, 
the final regulations clarify that the section 402(g) dollar limits are 
increased by the limit on catch-up contributions under section 414(v) 
for any year in which the service provider qualifies for such increase.
    Commentators raised issues concerning other types of plans under 
which a service provider must participate in a qualified plan to 
receive nonqualified deferred compensation. Specifically, commentators 
asked whether a plan could comply with section 409A if it provided that 
an employee must defer the maximum amount permissible under a qualified 
plan in order to defer any amount under a nonqualified deferred 
compensation plan. Where the service provider can change the service 
provider's election to defer the maximum amount permissible under the 
qualified plan during the taxable year, and thereby change or 
discontinue deferrals under a nonqualified deferred compensation plan, 
the service provider can effectively make a late election to defer (or 
not defer) amounts under the nonqualified plan. The final regulations 
generally do not provide any additional relief with respect to this 
type of plan. However, where the additional amounts deferred under the 
nonqualified deferred compensation plan reflect only matching 
contributions that would be available under the qualified plan absent 
the restrictions in the qualified plan intended to reflect limits on 
qualified plan contributions under sections 401(m) and 401(a)(17), the 
final regulations provide relief but solely with respect to the 
matching amount that could have been contributed to the qualified plan 
absent such limits.
    Commentators also stated that the rules in the proposed regulations 
did not adequately address the impact of after-tax contributions. 
Specifically, commentators requested relief for service providers who 
change their after-tax contributions (other than designated Roth 
contributions) under a qualified plan during a year where such decrease 
causes a corresponding change in nonqualified plan elective deferrals. 
The final regulations provide some additional relief concerning 
matching or other contributions contingent upon the making of an after-
tax contribution. However, other suggestions were not adopted in the 
final regulations, because the Treasury Department and the IRS are 
concerned that such plans may give the service provider excessive 
control over amounts deferred under a nonqualified deferred 
compensation plan, contrary to the statutory intent.
B. Plans Linked to Cafeteria Plans
    Commentators expressed concern that changes to elections under a 
section 125 cafeteria plan could change the amount of eligible 
compensation used for purposes of a benefit formula under a 
nonqualified deferred compensation plan and thereby create an 
impermissible deferral election or acceleration of payment under the 
nonqualified deferred compensation plan. The final regulations provide 
relief from the deferral election-timing and anti-acceleration rules 
for changes to section 125 elections properly made in accordance with 
the rules under section 125, to the extent that the change in the 
amount deferred under the nonqualified deferred compensation plan 
results solely from the application of the change in amount of eligible 
compensation resulting from the election change under the cafeteria 
plan to a benefit formula based upon the service provider's eligible 
compensation, and only to the extent that such change applies in the 
same manner as any other increase or decrease in the eligible 
compensation would apply to such benefit formula.
C. Offsets
i. In General
    Some commentators requested clarification whether an arrangement 
under which a specified amount paid by a service recipient to a service 
provider reduces or offsets an amount that is payable to the service 
provider under a nonqualified deferred compensation plan will be 
treated as providing for an acceleration of a payment under the 
nonqualified deferred compensation plan. As an example, one commentator 
stated that a plan may require that any payout at separation from 
service of accrued leave that is determined to be in excess of the 
correct amount of such payment will be deducted from the amount due 
under a nonqualified deferred compensation plan, rather than repaid 
separately by the service provider. One commentator suggested that 
offsets be permitted for all service provider debts of a kind and in 
amounts customarily incurred in the ordinary course of the business 
relationship between the service provider and the service recipient.
    The Treasury Department and the IRS believe that the unfettered 
discretion to settle debts between a service recipient and a service 
provider through offsets from payments of nonqualified deferred

[[Page 19271]]

compensation is not consistent with the intent of the statute, because 
it creates opportunities to disguise accelerated payments of deferred 
compensation. Accordingly, amounts that currently or in the future may 
be offset against nonqualified deferred compensation are treated as 
payments of deferred compensation and may violate the anti-acceleration 
rules under section 409A. See section VIII.A of this preamble. However, 
the Treasury Department and the IRS agree that the ability to offset 
small routine debts against amounts payable under a nonqualified 
deferred compensation plan is useful so that service recipients can 
avoid the administrative burden involved in paying deferred 
compensation amounts to a service provider while at the same time 
attempting to collect small amounts owed by the same service provider. 
Accordingly, the final regulations provide that payments of deferred 
compensation may be offset by amounts owed to the service recipient by 
the service provider, where such debt is incurred in the ordinary 
course of the service relationship, to the extent the entire offset in 
any taxable year does not exceed $5,000 and the offset is taken at the 
same time and in the same amount as the debt otherwise would have been 
due from the service provider.
ii. Social Security Benefits and Disability Benefits
    Commentators requested clarification of the treatment of 
nonqualified deferred compensation plans that offset benefits with 
payments received as Social Security benefits and disability benefits. 
A plan provision providing for a direct, dollar-for-dollar reduction of 
payments due under a nonqualified deferred compensation plan by the 
amount of payments received or receivable as Social Security benefits 
will not fail to provide for a fixed schedule of payments. However, the 
rule relates solely to direct reductions in deferred compensation 
benefits to reflect eligibility for, or payment of, Social Security 
benefits, and does not permit other changes in the time and form of 
benefit based upon a service provider's eligibility or elections 
related to Social Security benefits. A reduction in a nonqualified 
deferred compensation plan benefit equal to the amount receivable under 
a service recipient sponsored disability plan generally will be treated 
similarly, provided that a substantial number of service providers 
participate in the disability plan. However, to allow the payment 
schedule to qualify as a fixed schedule, the disability plan must be 
established before the date the service provider becomes disabled. In 
addition, any subsequent amendment to the disability plan or other 
change in the benefit payable under the disability plan may result in 
an acceleration of a payment or a subsequent deferral under the 
nonqualified deferred compensation plan unless the facts and 
circumstances establish otherwise (for example, because the amendment 
or change results from actions taken by an independent third party, 
such as an unrelated insurer that issued a disability insurance policy 
for such disability plan, over which the service recipient and service 
provider have no control, or an action of the service recipient with 
respect to the disability plan that is generally applicable to a 
substantial number of other service providers who participate in such 
disability plan and has a material effect on the disability benefits of 
such other service providers).

XI. Statutory Effective Dates

A. Effective Dates--Earned and Vested Amounts
    As provided in section 885(d) of the American Jobs Creation Act of 
2004, section 409A generally is effective for amounts deferred after 
December 31, 2004. The final regulations adopt the definition set forth 
in the proposed regulations of an amount deferred on or before December 
31, 2004, for purposes of the effective date, subject to the 
modifications described in this preamble. The final regulations clarify 
that the grandfathered amount includes any account balance that is 
earned and vested, as well as the present value of any earned and 
vested right to future account credits, even if such amounts had not 
been credited to the account as of December 31, 2004. For example, if a 
service provider had a vested right on December 31, 2004, to have a 
bonus amount added to the service provider's account balance in a 
nonqualified deferred compensation plan, the service provider's 
grandfathered amount would include the amount of such bonus even though 
such amount was not calculated and credited to the account until some 
time in 2005.
B. Effective Dates--Calculation of Grandfathered Amount
    One commentator requested that the grandfathered amount in a 
nonaccount balance plan be expressed in terms of the form of benefit 
under the plan. So, for example, where the normal benefit was expressed 
in the form of an annuity payable at a certain age, that is how the 
amount of the grandfathered benefit would also be expressed. The final 
regulations do not adopt this suggestion, but reach a similar result by 
providing that any actuarial assumptions and methods that were 
reasonable to use as of December 31, 2004, may continue to be used in 
subsequent years for purposes of determining the grandfathered amount.
C. Material Modifications
    Section 885(d)(2) of the American Jobs Creation Act of 2004 
provides generally that amounts deferred in taxable years beginning 
before January 1, 2005, are treated as amounts deferred in a taxable 
year beginning on or after such date if the plan under which the 
deferral is made is materially modified after October 3, 2004. The 
final regulations adopt the definition set forth in the proposed 
regulations of a material modification for these purposes, subject to 
the changes described in this preamble.
    For purposes of the definition of a material modification under the 
effective date rules, the final regulations incorporate the exclusions 
from the definition of a modification for purposes of the rules 
governing stock rights. For example, a change to a discounted 
grandfathered stock right that could be covered by section 409A if 
materially modified under the effective date rules, will not be treated 
as materially modified and subject to section 409A if the change would 
not be treated under the rules governing stock rights as a modification 
resulting in treatment as a new grant of a stock right or an extension 
resulting in treatment of the stock right as having had a deferral 
feature from the date of grant.
    The final regulations provide that neither the amendment of a plan 
to include a provision allowing for a payment to a person other than 
the service provider due to the application of a domestic relations 
order, nor the making of a payment in compliance with a domestic 
relations order where a plan did not address the ability to make such a 
payment, is treated as a material modification for purposes of the 
grandfathering rules.
    Commentators also requested that a grandfathered plan be permitted 
to remove a provision requiring a cancellation of deferrals for a 
prescribed period of time under all nonqualified deferred compensation 
plans to receive a distribution from the grandfathered plan, without 
resulting in a material modification. Commentators argued that because 
the enforcement of such a provision by cancelling a current deferral 
election generally would result in an immediate violation of section 
409A, the inability to remove the requirement that the deferral 
election be

[[Page 19272]]

cancelled effectively nullifies the grandfathered right. Under the 
final regulations, an amendment to a grandfathered plan that changes 
such a provision to require a cancellation of deferrals for the 
equivalent period of time beginning with the first possible date that 
such a cancellation would not result in a prohibited accelerated 
payment (generally the beginning of the subsequent calendar year for a 
service provider with a calendar year taxable year) will not constitute 
a material modification. For example, taxpayers may amend an early 
distribution provision that requires the immediate cessation of 
deferrals for 12 months to apply only to deferrals over the first 12 
month period with respect to which the service provider can make a 
timely deferral election, for example, by prohibiting deferrals of 
compensation attributable to services performed during the service 
provider's next taxable year.
    Commentators requested clarification of the effect of a material 
modification of a plan. The specific consequences of a material 
modification of a plan are being considered as part of the anticipated 
guidance related to income inclusion and calculation. However, the 
final regulations provide that for amounts deferred in taxable years 
beginning before January 1, 2005, under a plan that is materially 
modified after October 3, 2004, whether the plan complies with the 
requirements of section 409A is determined by reference to the terms of 
the plan in effect, and any actions taken under the plan, on and after 
the date of the material modification. Accordingly, where the 
materially modified plan is compliant with section 409A and these 
regulations immediately following the material modification, the 
material modification generally will not itself result in a violation.

XII. Effective Date of Final Regulations

A. Existing Transition Relief
    Nothing in this preamble or the final regulations is intended to 
restrict the otherwise applicable transition relief. For a description 
of the applicable transition relief, see Notice 2006-79, 2006-43 IRB 
763 (extension of certain transition relief through 2007), Notice 2006-
64, 2006-29 IRB 88 (transition relief applicable to certain accelerated 
payments necessary to comply with Federal ethics requirements), Notice 
2006-33, 2006-15 IRB 754 (transition rules with respect to section 
409A(b)), Notice 2006-4, 2006-3 IRB 307 (transition relief with respect 
to the valuation standards applicable to stock rights issued on or 
before the effective date of the final regulations for purposes of the 
exclusion from coverage under section 409A for certain stock rights), 
the preamble to the proposed regulations (extension of certain 
transition relief through 2006), and Notice 2005-1, 2005-1 CB 274 
(initial transition relief). See Sec.  601.601(d)(2).
B. Application of Final Regulations
    The final regulations are generally effective January 1, 2008. For 
periods before January 1, 2008, the standards and transition rules set 
forth in Notice 2006-79 continue to apply. For further information 
regarding the transition relief for periods before the effective date 
of the final regulations, see Notice 2006-79 and section XI of the 
preamble to the proposed regulations.
    Commentators requested clarification of the impact of the final 
regulations becoming effective January 1, 2008, on plans that continue 
to defer compensation on or after January 1, 2008. Specifically, 
commentators asked whether actions taken with respect to nonqualified 
deferred compensation plans that would not have resulted in income 
inclusion under section 409A before 2008 because such actions were 
consistent with applicable guidance, but would not be consistent with 
the final regulations, would need to be modified to avoid income 
inclusion under section 409A in 2008 and later years. The following 
sections discuss the effect of the final regulations with respect to 
the requirements necessary to comply with section 409A, including the 
various requirements necessary for a plan to be excluded from coverage 
under section 409A.
C. Stock Rights
    Many of the comments related to stock options and stock 
appreciation rights. Some commentators requested that section 409A not 
apply to any stock rights issued before the effective date of the final 
regulations. Neither the statute nor the legislative history indicates 
an intent for such a broad exception. The Treasury Department and the 
IRS understand that certain aspects of the guidance on stock rights 
have changed. However, the final regulations generally expand the 
exclusion from coverage under section 409A for certain stock rights to 
eliminate many issues raised by the proposed regulations. In addition, 
with respect to certain types of stock rights, such as discounted stock 
options, the guidance has explicitly and consistently indicated that 
either rights that would be excluded from coverage under section 409A 
must be substituted for such rights or such rights must be modified to 
comply with section 409A. Accordingly, the final regulations do not 
adopt a categorical exclusion from coverage under section 409A of all 
stock rights issued before the issuance of the final regulations.
    Commentators also asked whether a stock option must be repriced to 
avoid coverage under section 409A if the exercise price would be 
treated as having been set at fair market value under section 409A 
under the applicable guidance, but would not be treated as having been 
set at fair market value if the standard of the final regulations had 
been applicable. For this purpose, the guidance provided in Notice 
2006-4, 2006-3 IRB 307, see Sec.  601.601(d)(2), remains in effect. 
Notice 2006-4 provided certain standards applicable to stock rights 
issued before January 1, 2005, for determining whether the exercise 
price of such stock right would be treated as having been set at fair 
market value for purposes of the exclusion from coverage under section 
409A for certain stock rights. As provided in Notice 2006-4, for stock 
rights issued before January 1, 2005, the standards applicable to 
incentive stock options under section 422 are applicable. Generally 
this means that where the sole reason the stock right would fail to 
qualify for the exclusion from coverage under section 409A is due to 
the exercise price not being set at or above fair market value, the 
exercise price will be treated as set at or above fair market value if 
based upon a good faith attempt by the issuer to set the exercise price 
at or above fair market value. As further explained in Notice 2006-4, 
for stock rights issued on or after January 1, 2005, but before January 
1, 2008, the provisions of Notice 2005-1 will apply, generally 
requiring that fair market value for purposes of setting the exercise 
price of a stock right must be determined using a reasonable valuation 
method. In addition, for stock rights issued on any date before January 
1, 2008, taxpayers may rely upon the provisions of the proposed or 
final regulations with regard to the determination of the fair market 
value of the underlying stock.
    Commentators requested that taxpayers not be required to bring 
stock rights granted before January 1, 2008, into compliance with 
section 409A if such rights were properly treated as not being subject 
to section 409A under the applicable guidance, but instead be permitted 
to keep such rights outstanding and unmodified.
    The final regulations significantly expand the permissible classes 
of stock and the permissible issuers of stock under the service 
recipient stock rule,

[[Page 19273]]

and taxpayers may rely on the final regulations for periods before the 
effective date of the final regulations. In addition, with respect to 
stock rights issued before April 10, 2007 on stock that would have 
constituted service recipient stock under a reasonable good faith 
interpretation of the statute and applicable guidance, but would not 
constitute service recipient stock under the final regulations, such 
stock will continue to constitute service recipient stock for purposes 
of applying section 409A to such stock right until the exercise or 
termination of such right, or until the stock right is modified in a 
manner that is treated as the grant of a new right. However, for a 
stock right issued on or after April 10, 2007, stock subject to such 
stock right will not be treated as service recipient stock after 
December 31, 2007, unless such stock satisfies the requirements of the 
final regulations, and if the stock does not satisfy these 
requirements, such stock right will be required to be modified either 
to be excluded from coverage under section 409A, or to comply with the 
requirements of section 409A and these regulations.
    Commentators also expressed concerns about modifications and 
extensions of stock rights that occur before January 1, 2008. Different 
concerns and arguments arise depending upon whether these modifications 
and extensions occurred on or before the enactment of the statute 
(October 23, 2004), on or before the issuance of Notice 2005-1 
(December 20, 2004), on or before the issuance of the proposed 
regulations (September 30, 2005) or on or before the effective date of 
the final regulations (January 1, 2008). The final regulations 
significantly expand the permissible types of modifications and 
extensions that will not result in treatment of the stock right as a 
new grant or as having had a deferral feature from the date of grant, 
and taxpayers may rely on these regulations for periods before the 
effective date of the regulations. In addition, any modifications or 
extensions occurring before the enactment of the statute (October 23, 
2004) will not be considered in determining whether the right is 
excluded from coverage under section 409A. Finally, any extension 
granted before April 10, 2007 solely in order to give the holder of a 
stock right an additional period of time within which to exercise the 
stock right beyond the time originally prescribed is disregarded for 
purposes of the rules treating certain extensions as deferral features 
from the time of grant. See Sec.  1.409A-1(b)(5)(v)(C).
D. Initial Deferral Elections
    Commentators asked whether and to what extent the final regulations 
would impact initial deferral elections made before the effective date 
of the final regulations. If a deferral election made before January 1, 
2008, was consistent with the proposed regulations or the applicable 
transition guidance, the initial deferral election will be deemed to 
comply with the provisions of section 409A, regardless of whether the 
period of deferral extends beyond December 31, 2007.
    In addition, commentators asked whether and to what extent the 
final regulations would impact programs established before the 
effective date of the final regulations, where initial deferral 
elections have not been made by January 1, 2008. For example, 
commentators asked how section 409A would apply if a service recipient 
has interpreted a program as providing for performance-based 
compensation and permitted deferral elections to occur in 2008 or later 
in accordance with the rules governing deferrals of performance-based 
compensation, but such compensation does not qualify as performance-
based compensation under the final regulations. For a program 
established before April 10, 2007 that under a reasonable, good faith 
interpretation of the statute and applicable guidance would have 
permitted an initial deferral election to be made after December 31, 
2007, and on or before December 31, 2008, an initial deferral election 
will be deemed to comply with the initial deferral election rules if 
made by the deadline established in the plan. For a program established 
before April 10, 2007 that under a reasonable, good faith 
interpretation of the statute and applicable guidance would have 
permitted an initial deferral election to be made after December 31, 
2008, an initial deferral election will be deemed to comply with the 
initial deferral election rules if made by December 31, 2008.
E. Designation of Time and Form of Payment
    Notice 2005-1 and the preamble to the proposed regulations 
consistently provide that elections as to the time and form of payment 
of deferred compensation would need to be compliant with the final 
regulations by the time such regulations were effective. Both Notice 
2005-1 and the preamble to the proposed regulations provide detailed 
transition guidance, generally permitting service providers and service 
recipients to change the time and form of payment at any time through 
the end of the transition period. Accordingly, a payment scheme that 
violates the provisions of the final regulations will need to be 
brought into compliance with the final regulations in accordance with 
the transition relief.
F. Service Providers in Pay Status
    Commentators asked how the final regulations apply to service 
providers that are already in pay status, where the payment trigger is 
based upon a reasonable, good faith interpretation of the statute and 
applicable guidance but is not in compliance with the final 
regulations. This may occur where the service provider has already 
begun receiving payments before January 1, 2008, or where all events 
necessary to receive the payment have occurred before January 1, 2008. 
For example, a service provider may have been treated as having 
separated from service before January 1, 2008, under a reasonable, good 
faith interpretation of the statute, but would not be treated as having 
separated from service under the final regulations. Where payments have 
commenced before January 1, 2008, the plan may continue to make such 
payments consistent with the application of the plan terms at the time 
the payments commenced, or may halt such payments on or before December 
31, 2007, and amend the time and form of any remaining payments to 
comply with the final regulations in accordance with the transition 
guidance provided. Where payments have not commenced by January 1, 
2008, but all the events necessary to receive the payment have 
occurred, the plan may make payments in accordance with the application 
of the plan terms on December 31, 2007, or may amend the time and form 
of payments to comply with section 409A in accordance with the 
transition guidance provided. Similarly, where payments have not 
commenced on or before December 31, 2007, because the service provider 
was treated as not having separated from service under a reasonable, 
good faith interpretation, but under the final regulations the service 
provider would be treated as having separated from service on or before 
December 31, 2007, the plan must treat the service provider as having 
separated from service on a date on or after April 10, 2007 and on or 
before December 31, 2007. Nothing in this paragraph is to be construed 
to permit the continuation of any payment schedule based upon an 
application of section 409A on or before December 31, 2007, that failed 
to meet the requirements of the applicable transition guidance. In 
addition, nothing

[[Page 19274]]

in this paragraph is intended to waive the application of the 
constructive receipt doctrine or section 451 with respect to any 
discretion provided to the service provider (or former service 
provider) with respect to the application of these provisions.
    In addition, commentators asked how the final regulations would 
apply in the case of the six-month delay for specified employees of 
public corporations. Where a separation from service occurs on or 
before December 31, 2007, under circumstances that under a reasonable, 
good faith interpretation of the statute and applicable guidance would 
not result in application of the six-month delay requirement for a 
payment to a specified employee, the beginning or continuation of 
payments of deferred compensation on or after January 1, 2008, will not 
result in a violation of the six-month delay requirement for a payment 
to a specified employee.

XIII. Additional Transition Relief

A. Collectively Bargained Plans
    Consistent with Notice 2006-79, Sec.  3.05, the final regulations 
provide that a nonqualified deferred compensation plan maintained 
pursuant to one or more collective bargaining agreements in effect on 
October 3, 2004, is not required to comply with the provisions of 
section 409A on or before the earlier of the date on which the last of 
such collective bargaining agreements terminates (determined without 
regard to any extension of any agreement after October 3, 2004) or 
December 31, 2009.
    With respect to amounts deferred under a nonqualified deferred 
compensation plan maintained pursuant to one or more collective 
bargaining agreements in effect on October 3, 2004, the plan may 
provide, or be amended to provide, for new payment elections with 
respect to both the time and form of payment of such amounts, and the 
election or amendment will not be treated as a change in the time or 
form of 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 elections are made before the date on which section 409A first 
applies to such plan. A deferral election may be made with respect to 
an amount that is a short-term deferral within the meaning of Sec.  
1.409A-1(b)(4), provided that the election is made before the date on 
which section 409A would apply to an amount deferred under such plan 
and before January 1 of the calendar year in which the amount would 
otherwise have been paid.
B. Requirement To Amend Plans on or Before December 31, 2007
    Where there have been deferrals of compensation under a plan as of 
January 1, 2008 but the deferred compensation has not been paid, the 
plan must be made compliant with section 409A on or before December 31, 
2007, with respect to such deferred compensation. These amendments are 
required only to bring the document into compliance effective January 
1, 2008, and are not required to reflect any amendments made or actions 
taken under the transition rules to the extent such amendments or 
actions do not affect the plan's compliance with section 409A and these 
regulations for periods on or after January 1, 2008. For example, if a 
plan contains a haircut provision permitting an immediate distribution 
contingent on the forfeiture of a certain portion of a deferred amount, 
the haircut provision need not be removed retroactively for periods 
before January 1, 2008, where the plan has been operated in compliance 
with the applicable transition guidance (and thus no payment pursuant 
to the haircut provision has been made after December 31, 2004). In 
addition, a plan need not be amended to be made compliant with section 
409A with respect to amounts deferred under the plan that were paid on 
or before December 31, 2007, in compliance with the transition 
guidance. However, the taxpayer must be able to demonstrate that the 
plan was operated in compliance with the transition guidance, including 
demonstrating that amounts were deferred or paid in compliance with the 
transition rules. For example, where payments were made in conjunction 
with elections of payment dates by either the service recipient or 
service provider during the transition period, the taxpayer must be 
able to demonstrate that the elections were provided and made in 
accordance with the transition rules.

XIV. Calculation and Timing of Income Inclusion Amounts, Reporting and 
Withholding

A. In General
    These regulations do not address the calculation and timing of 
amounts required to be included in income under section 409A(a). Nor do 
these regulations address the reporting and withholding requirements 
applicable to service recipients providing nonqualified deferred 
compensation covered by section 409A. The Treasury Department and the 
IRS intend to issue further guidance, including such transition 
guidance as may be appropriate with respect to the reporting and 
withholding requirements. See Notice 2006-100, 51 IRB 1109, for 
transition rules applicable to the reporting and withholding 
requirements for 2005 and 2006. See Sec.  601.601(d)(2).
B. Operational Violations During the Transition Period
    Commentators on the proposed regulations and Notice 2006-100 asked 
whether a service provider whose nonqualified deferred compensation 
plan violated section 409A in operation before January 1, 2008, would 
be required to include an amount in income under section 409A only in 
the taxable year of the service provider in which the operational 
failure occurred (assuming this was the only year of an operational 
failure), or in such year and all prior years beginning after December 
31, 2004. Commentators argued that for years before the operational 
violation, the taxpayer could be treated as operating the plan in 
reasonable, good faith compliance with the statute and Notice 2005-1, 
and therefore should be required to include an amount in income under 
section 409A only for the year in which the operational violation 
occurred. For example, where a taxpayer exercised a discounted stock 
option covered by section 409A in 2006, commentators argued that the 
taxpayer should be treated as operating the plan in reasonable, good 
faith compliance with section 409A during 2005, so that the taxpayer 
would be required to include an amount in income as a result of the 
section 409A violation only to 2006.
    Where an operational failure occurs in 2006 or 2007, and no 
operational failures occurred in any prior year, the taxpayer 
(including the service recipient) may report the amounts required to be 
included in income under section 409A as taxable income only in the 
year of the operational failure. In addition, where the violation 
results from a payment, a taxpayer may include the required amount in 
income only for the year in which such violation occurs, regardless of 
whether the portion of the deferred compensation plan under which such 
payment was made is ever amended to comply with the requirements of 
section 409A for periods before such payment. For example, where a 
taxpayer exercises a discounted stock option subject to section 409A in 
2006, and there was no operational violation in 2005, the taxpayer may 
include an amount in income under section 409A for 2006, and the 
taxpayer will not be required to include an amount in income with 
respect to such stock option for 2005,

[[Page 19275]]

even if the taxpayer does not amend the stock option to comply with 
section 409A for 2005. However, where all or part of the total amount 
deferred in the year of the violation was also an amount deferred in 
one or more prior years that was not subject to a substantial risk of 
forfeiture in such year, taxpayers are also required to calculate and 
pay any applicable tax under section 409A(a)(1)(B)(i)(I) (based on the 
amount of interest determined under section 409A(a)(1)(B)(ii)). For 
example, if the discounted stock right in the previous example was not 
subject to a substantial risk of forfeiture as of December 31, 2005, 
the taxpayer would be required to compute and report the additional tax 
under section 409A(a)(1)(B)(i)(I) on the taxpayer's 2006 return. For 
purposes of this paragraph, the service recipient should treat the 
application of section 409A in the same manner for purposes of income 
tax withholding and reporting obligations.
C. Application of Plan Aggregation Rules During the Transition Period
    Notice 2006-100 provides that where there is a required income 
inclusion under section 409A in 2006, the plan aggregation rules apply 
in determining the amount includible in income. Commentators asked 
whether the plan aggregation rules would apply where the taxpayer 
violates section 409A in 2006 with respect to one arrangement (the 
first arrangement), but retains the right to modify another arrangement 
(the second arrangement) to exclude a right to an amount provided under 
the second arrangement from coverage under section 409A, where the 
second arrangement would otherwise be aggregated with the first 
arrangement. For this purpose, if the legally binding right to the 
amount under the second arrangement ultimately is modified (including, 
where permitted by applicable guidance, by the substitution of another 
right for such right), so that the right to the amount is excluded from 
coverage under section 409A, then the right to the amount is treated as 
always having been excluded from coverage under section 409A. 
Accordingly, the amount payable under the second arrangement would not 
be required to be aggregated with the first arrangement for purposes of 
determining the amount includible in income under section 409A. 
However, if the right to the amount under the second arrangement is not 
timely modified to be excluded from coverage under section 409A, the 
right to the amount under the second arrangement will remain subject to 
the plan aggregation rules regardless of whether the second arrangement 
is, or is amended to be, compliant with the requirements of section 
409A. In such a case, because the right to the amount under the second 
arrangement could have been modified to be excluded from coverage under 
section 409A, and would not have been subject to the plan aggregation 
rules, the violation with respect to the second arrangement is not 
treated as occurring until the first taxable year of the service 
provider during which the arrangement could not have been so modified.
    For example, assume a taxpayer with a calendar year taxable year 
exercised a discounted stock right during 2006 in violation of section 
409A and that the taxpayer held another unexercised discounted stock 
right described in Notice 2006-79, Sec.  3.07 (relating to certain 
stock rights issued to corporate insiders) that could have been 
modified by December 31, 2006, to be excluded from coverage (by 
exchanging such stock right for another stock right pursuant to the 
preamble to the proposed regulations). If the unexercised stock right 
was not so modified by December 31, 2006, it would violate section 409A 
on January 1, 2007. Alternatively, assume a second taxpayer exercised a 
discounted stock right in 2006 in violation of section 409A and that 
taxpayer held another unexercised discounted stock right (not described 
in Notice 2006-79, Sec.  3.07) that could have been modified by 
December 31, 2007, to be excluded from coverage. If the second taxpayer 
failed to timely modify such unexercised stock right, the unexercised 
stock right would violate section 409A on January 1, 2008.
D. Failures to Amend During the Transition Period to Comply With the 
Rules of Section 409A
    Commentators asked how section 409A and these regulations would 
apply to a plan that was operated in compliance with the transition 
guidance through December 31, 2007, but is not amended to become 
compliant with section 409A and these regulations by December 31, 2007. 
For these purposes, the plan will be treated as failing to comply with 
the requirements of section 409A and these regulations as of January 1, 
2008, so that no amounts will be required to be included in income 
under section 409A with respect to such a violation for any taxable 
year ending before January 1, 2008. However, this does not affect the 
application of the tax imposed by section 409A(a)(1)(B)(i)(I) to 
amounts that were deferred in taxable years ending before January 1, 
2008, to the extent that such amounts were not subject to a substantial 
risk of forfeiture in one or more of such earlier taxable years.

XV. Offshore Trusts and Arrangements With Financial Triggers

    These regulations do not address the application of section 
409A(b), generally prohibiting the use of offshore trusts associated 
with nonqualified deferred compensation plans, and the use of triggers 
whereby amounts held in a trust or other arrangement become restricted 
to the use for payment of nonqualified deferred compensation upon an 
event related to the financial health of the service recipient. For 
transition guidance related to the application of section 409A(b) to 
certain outstanding arrangements, see Notice 2006-33, 2006-15 IRB 754. 
See Sec.  601.601(d)(2). Taxpayers may continue to rely upon Notice 
2006-33 until further guidance is issued.

Applicability Date

    These regulations are applicable for taxable years beginning on or 
after January 1, 2008. Taxpayers may relay on the provisions of these 
final regulations for taxable years beginning before January 1, 2008.

Effect on Other Documents

    Notice 2005-1, 2005-1 CB 274, is obsoleted for taxable years 
beginning on or after January 1, 2008, except for the following 
sections of the guidance which remain effective as modified by any 
other applicable guidance: Q&A-6 (application to arrangements covered 
by section 457); Q&A-7 (application to arrangements between a 
partnership and a partner of the partnership); and Q&A-24 through Q&A-
38 (information reporting and withholding guidance). For a discussion 
of the effect of reliance upon Notice 2005-1 or the proposed 
regulations for taxable years beginning before January 1, 2008, for 
arrangements continuing into taxable years beginning on or after 
January 1, 2008, see section XII of this preamble. See Sec.  
601.601(d)(2).
    Notice 2006-4, 2006-3 IRB 307, addressing certain stock rights 
issued before January 1, 2008, is superseded by these final regulations 
with respect to stock rights issued in taxable years of the service 
provider beginning on or after January 1, 2008. For a discussion of the 
effect of reliance upon Notice 2005-1, Notice 2006-4, or the proposed 
regulations for taxable years beginning before January 1, 2008, for 
stock rights remaining outstanding on or after January 1, 2008, see 
section XII of this preamble.
    Notice 2006-33, 2006-15 IRB 754, Notice 2006-79, 2006-43 IRB 763, 
and Notice 2006-100, 2006-51 IRB 1109, are

[[Page 19276]]

not affected by these final regulations. Notice 2006-64, 2006-29 IRB 
88, is superseded by the final regulations effective for taxable years 
of a service provider beginning on or after January 1, 2008. See Sec.  
601.601(d)(2).

Special Analyses

    It has been determined that this Treasury decision 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, the notice of proposed 
rulemaking preceding these regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

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.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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


0
Par. 2. Sections 1.409A-0 through 1.409A-6 are added to read as 
follows:


Sec.  1.409A-0  Table of contents.

    This section lists captions contained in Sec. Sec.  1.409A-1, 
1.409A-2, 1.409A-3, 1.409A-4, 1.409A-5 and 1.409A-6.

Sec.  1.409A-1 Definitions and covered plans.

(a) Nonqualified deferred compensation plan.
(1) In general.
(2) Qualified employer plans.
(3) Certain foreign plans.
(i) Participation addressed by treaty.
(ii) Participation by nonresident aliens, certain resident aliens, 
and bona fide residents of possessions.
(iii) Participation by U.S. citizens and lawful permanent residents.
(iv) Plans subject to a totalization agreement and similar plans.
(v) Broad-based foreign retirement plan.
(4) Section 457 plans.
(5) Certain welfare benefits.
(b) Deferral of compensation
(1) In general.
(2) Earnings.
(3) Compensation payable pursuant to the service recipient's 
customary payment timing arrangement.
(4) Short-term deferrals.
(i) In general.
(ii) Certain delayed payments.
(iii) Examples.
(5) Stock options, stock appreciation rights, and other equity-based 
compensation.
(i) Stock rights.
(A) Nonstatutory stock options not providing for the deferral of 
compensation.
(B) Stock appreciation rights not providing for the deferral of 
compensation.
(C) Stock rights that may provide for the deferral of compensation.
(D) Feature for the deferral of compensation.
(E) Rights to dividends.
(ii) Statutory stock options.
(iii) Service recipient stock.
(A) In general.
(B) American depositary receipts.
(C) Mutual company units.
(D) Other entities.
(E) Eligible issuer of service recipient stock.
(1) In general.
(2) Investment vehicles.
(3) Corporate structures established or transactions undertaken for 
purposes of avoiding coverage under section 409A.
(4) Substitutions and assumptions by reason of a corporate 
transaction.
(iv) Determination of the fair market value of service recipient 
stock.
(A) Stock readily tradable on an established securities market.
(B) Stock not readily tradable on an established securities market.
(1) In general.
(2) Presumption of reasonableness.
(3) Use of alternative methods.
(v) Modifications, extensions, substitutions, and assumptions of 
stock rights.
(A) Treatment of modified and extended stock rights.
(B) Modification in general.
(C) Extensions.
(1) In general.
(2) Certain extensions before April 10, 2007.
(3) Examples.
(D) Substitutions and assumptions of stock rights by reason of a 
corporate transaction.
(E) Acceleration of date when exercisable.
(F) Discretionary added benefits.
(G) Change in underlying stock increasing value.
(H) Change in the number of shares purchasable.
(I) Rescission of changes.
(J) Successive modifications and extensions.
(K) Modifications and extensions in effect on October 23, 2004.
(vi) Meaning and use of certain terms.
(A) Option.
(B) Date of grant of option.
(C) Stock.
(D) Exercise price.
(E) Exercise.
(F) Transfer.
(G) Readily tradable.
(H) Application to stock appreciation rights.
(6) Restricted property, section 402(b) trusts, and section 403(c) 
annuities.
(i) In general.
(ii) Promises to transfer property.
(7) Arrangements between partnerships and partners. [Reserved]
(8) Certain foreign plans.
(i) Plans with respect to compensation covered by treaty or other 
international agreement.
(ii) Plans with respect to certain other compensation.
(iii) Tax equalization agreements.
(iv) Certain limited deferrals of a nonresident alien.
(v) Additional foreign plans.
(vi) Earnings.
(9) Separation pay plans.
(i) In general.
(ii) Collectively bargained separation pay plans.
(iii) Separation pay due to involuntary separation from service or 
participation in a window program.
(iv) Foreign separation pay plans.
(v) Reimbursements and certain other separation payments.
(A) In general.
(B) Medical benefits.
(C) In-kind benefits and direct service recipient payments.
(D) Limited payments.
(E) Limited period of time.
(vi) Window programs--definition.
(10) Certain indemnification and liability insurance plans.
(11) Legal settlements.
(12) Certain educational benefits.
(c) Plan.
(1) In general.
(2) Plan aggregation rules.
(i) In general.
(ii) Dual status.
(3) Establishment of plan.
(i) In general.
(ii) Initial deferral election provisions.
(iii) Subsequent deferral election provisions.
(iv) Payment accelerations.
(v) Six-month delay for specified employees.
(vi) Plan amendments.
(vii) Transition rule for written plan requirement.
(viii) Plan aggregation rules.
(d) Substantial risk of forfeiture.
(1) In general.
(2) Stock rights.
(3) Enforcement of forfeiture condition.
(i) In general.
(ii) Examples.
(e) Performance-based compensation.
(1) In general.
(2) Payments based upon subjective performance criteria.
(3) Equity-based compensation.
(f) Service provider.
(1) In general.
(2) Independent contractors.
(i) In general.
(ii) Related person.
(iii) Significant services.

[[Page 19277]]

(iv) Management services.
(v) Services provided to related persons.
(g) Service recipient.
(h) Separation from service.
(1) Employees.
(i) In general.
(ii) Termination of employment.
(2) Independent contractors.
(i) In general.
(ii) Special rule.
(3) Definition of service recipient and employer.
(4) Asset purchase transactions.
(5) Dual status.
(6) Collectively bargained plans covering multiple employers.
(i) Specified employee.
(1) In general.
(2) Definition of compensation.
(3) Specified employee identification date.
(4) Specified employee effective date.
(5) Alternative methods of satisfying the six-month delay rule.
(6) Corporate transactions.
(i) Mergers and acquisitions of public service recipients.
(ii) Mergers and acquisitions of nonpublic service recipients.
(iii) Spinoffs.
(iv) Public offerings and other corporate transactions.
(v) Alternative methods of compliance.
(7) Nonresident alien employees.
(8) Elections affecting the identification of specified employees.
(j) Nonresident alien.
(k) Established securities market.
(l) Stock right.
(m) Separation pay plan.
(n) Involuntary separation from service.
(1) In general.
(2) Separations from service for good reason.
(i) In general.
(ii) Safe harbor.
(3) Special rule for certain collectively bargained plans.
(o) Earnings.
(p) In-kind benefits.
(q) Application of definitions and rules.

Sec.  1.409A-2 Deferral elections.

(a) Initial elections as to the time and form of payment.
(1) In general.
(2) Service recipient elections.
(3) General rule.
(4) Initial deferral election with respect to short-term deferrals.
(5) Initial deferral election with respect to certain forfeitable 
rights.
(6) Initial deferral election with respect to fiscal year 
compensation.
(7) First year of eligibility.
(i) In general.
(ii) Eligibility to participate.
(iii) Application to excess benefit plans.
(8) Initial deferral election with respect to performance-based 
compensation.
(9) Nonqualified deferred compensation plans linked to qualified 
employer plans or certain other arrangements.
(10) Changes in elections under a cafeteria plan.
(11) Initial deferral election with respect to certain separation 
pay.
(12) Initial deferral election with respect to certain commissions.
(i) Sales commission compensation.
(ii) Investment commission compensation.
(iii) Commission compensation and related persons.
(13) Initial deferral election with respect to compensation paid for 
final payroll period.
(i) In general.
(ii) Transition rule.
(14) Elections to annualize recurring part-year compensation.
(15) USERRA rights.
(b) Subsequent changes in time and form of payment.
(1) In general.
(2) Definition of payments for purposes of subsequent changes in the 
time and form of payment.
(i) In general.
(ii) Life annuities.
(A) In general.
(B) Certain features disregarded.
(C) Subsidized joint and survivor annuities.
(D) Actuarial assumptions and methods.
(iii) Installment payments.
(iv) Transition rule.
(3) Beneficiaries.
(4) Domestic relations orders.
(5) Coordination with prohibition against acceleration of payments.
(6) Application to multiple payment events.
(7) Delay of payments under certain circumstances.
(i) Payments subject to section 162(m).
(ii) Payments that would violate Federal securities laws or other 
applicable law.
(iii) Other events and conditions.
(8) USERRA rights.
(9) Examples.
(c) Special rules for certain resident aliens.

Sec.  1.409A-3 Permissible payments

(a) In general.
(b) Designation of payment upon a permissible payment event.
(c) Designation of alternative specified dates or payment schedules 
based upon date of permissible event.
(d) When a payment is treated as made upon the designated payment 
date.
(e) Designation of time and form of payment with respect to 
earnings.
(f) Substitutions.
(g) Disputed payments and refusals to pay.
(h) Special rule for certain resident aliens.
(i) Definitions and special rules.
(1) Specified time or fixed schedule.
(i) In general.
(ii) Payment schedules with formula and fixed limitations.
(A) Individual limitations.
(B) Limitations on aggregate payments to all participants in 
substantially identical plans.
(iii) Payment schedules determined by timing of payments received by 
the service recipient.
(iv) Reimbursement or in-kind benefit plans.
(A) General rule.
(B) Medical reimbursement arrangements.
(v) Tax gross-up payments.
(vi) Examples.
(2) Separation from service--required delay in payment to a 
specified employee pursuant to a separation from service.
(i) In general.
(ii) Application of payment rules to delayed payments.
(3) Unforeseeable emergency.
(i) Definition.
(ii) Amount of payment permitted upon an unforeseeable emergency.
(iii) Payments due to an unforeseeable emergency.
(4) Disability.
(i) In general.
(ii) Limited plan definition of disability.
(iii) Determination of disability.
(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.
(ii) Identification of relevant corporation.
(A) In general.
(B) Majority shareholder.
(C) Example.
(iii) Attribution of stock ownership.
(iv) Special rules for certain delayed payments pursuant to a change 
in control event.
(A) Certain transaction-based compensation.
(B) Certain nonvested compensation.
(v) Change in the ownership of a corporation.
(A) In general.
(B) Persons acting as a group.
(vi) Change in the effective control of a corporation.
(A) In general.
(B) Multiple change in control events.
(C) Acquisition of additional control.
(D) Persons acting as a group.
(vii) Change in the ownership of a substantial portion of a 
corporation's assets.
(A) In general.
(B) Transfers to a related person.
(C) Persons acting as a group.
(6) Certain back-to-back arrangements.
(i) In general.
(ii) Example.
(j) Prohibition on acceleration of payments.
(1) In general.
(2) Application to multiple payment events.
(3) Beneficiaries.
(4) Exceptions.
(i) In general.
(ii) Domestic relations order.
(iii) Conflicts of interest.
(A) Compliance with ethics agreements with the Federal government.
(B) Compliance with ethics laws or conflicts of interest laws.
(iv) Section 457 plans.
(v) Limited cashouts.
(vi) Payment of employment taxes.
(vii) Payment upon income inclusion under section 409A.
(viii) Cancellation of deferrals following an unforeseeable 
emergency or hardship distribution.
(ix) Plan terminations and liquidations.
(x) Certain distributions to avoid a nonallocation year under 
section 409(p).
(xi) Payment of state, local, or foreign taxes.
(xii) Cancellation of deferral elections due to disability.
(xiii) Certain offsets.
(xiv) Bona fide disputes as to a right to a payment.
(5) Nonqualified deferred compensation plans linked to qualified 
employer plans or certain other arrangements.
(6) Changes in elections under a cafeteria plan.


[[Page 19278]]


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

Sec.  1.409A-5 Funding [Reserved]

Sec.  1.409A-6 Application of section 409A and effective dates.

(a) Statutory application and effective dates
(1) Application to amounts deferred.
(i) In general.
(ii) Collectively bargained plans.
(2) Identification of date of deferral for statutory effective date 
purposes.
(3) Calculation of amount of compensation deferred for statutory 
effective date purposes.
(i) Nonaccount balance plans.
(ii) Account balance plans.
(iii) Equity-based compensation plans.
(iv) Earnings.
(v) Definition of plan.
(4) Material modifications.
(i) In general.
(ii) Adoptions of new plans.
(iii) Suspension or termination of a plan.
(iv) Changes to investment measures--account balance plans.
(v) Stock rights.
(vi) Rescission of modifications.
(vii) Definition of plan.
(b) Regulatory applicability date.


Sec.  1.409A-1  Definitions and covered plans.

    (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). 
Whether a plan provides for the deferral of compensation generally is 
determined at the time the service provider obtains a legally binding 
right to the compensation under the plan, and is not affected by any 
retroactive change to the plan to characterize the right as one that 
does not provide for the deferral of compensation. For example, amounts 
deferred under a nonqualified deferred compensation plan do not become 
an excluded death benefit if the plan is amended so that the amounts 
are payable only upon the death of the service provider. If a principal 
purpose of a plan is to achieve a result with respect to a deferral of 
compensation that is inconsistent with the purposes of section 409A, 
the Commissioner may treat the plan as a nonqualified deferred 
compensation plan for purposes of section 409A and the regulations 
thereunder.
    (2) Qualified employer plans. The term nonqualified deferred 
compensation plan does not include a qualified employer plan. The term 
qualified employer plan means any of the following plans:
    (i) Any plan described in section 401(a) and a trust exempt from 
tax under section 501(a) or that is described in section 402(d).
    (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 plan under which an active participant makes deductible 
contributions to a trust described in section 501(c)(18).
    (vii) Any eligible deferred compensation plan (within the meaning 
of section 457(b)).
    (viii) Any plan described in section 415(m).
    (ix) Any plan described in Sec.  1022(i)(2) of the Employee 
Retirement Income Security Act of 1974, Public Law 93-406 (88 Stat. 
829, 942) (Sept. 2, 1974) (ERISA).
    (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, 
arrangement, or plan maintained with respect to such individual, to the 
extent contributions made by or on behalf of such individual to such 
scheme, trust, arrangement, or plan, or credited allocations, accrued 
benefits, earnings, or other amounts constituting income, of such 
individual under such scheme, trust, arrangement, or plan, are 
excludable by such individual for Federal income tax purposes pursuant 
to any bilateral income tax convention to which the United States is a 
party.
    (ii) Participation by nonresident aliens, certain resident aliens, 
and bona fide residents of possessions. With respect to an alien 
individual for a taxable year during which such individual is a 
nonresident alien, a resident alien classified as a resident alien 
solely under section 7701(b)(1)(A)(ii) (and not section 
7701(b)(1)(A)(i)), or a bona fide resident of a possession (within the 
meaning of section 937(a)), 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).
    (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), other 
than an individual who is also a bona fide resident of a possession 
(within the meaning of section 937(a)), 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), but 
only with respect to a plan, or a portion of a plan where such portion 
may be distinguished, providing for nonelective deferrals of modified 
foreign earned income, and earnings with respect to such nonelective 
deferrals, and only to the extent that the amounts deferred under all 
such plans of the service recipient, or all portions of such plans, in 
which the service provider participates in such taxable year, do not 
exceed the applicable limits under section 415(b) (applied to 
nonaccount balance plans as defined in paragraph (c)(2)(i)(C) of this 
section) and section 415(c) (applied to account balance plans as 
defined in paragraph (c)(2)(i)(A) of this section) that would be 
applicable if such plans were plans subject to section 415 and the 
modified foreign earned income of such individual were treated as 
compensation for purposes of applying section 415(b) and (c). For 
purposes of this paragraph (a)(3)(iii), the term modified foreign 
earned income means foreign earned income as defined in section 
911(b)(1) without regard to section 911(b)(1)(B)(iv) and without regard 
to the requirement that the income be attributable to services 
performed during the period described in section 911(d)(1)(A) or (B). 
The provisions of this paragraph (a)(3)(iii) do not apply to any 
individual with respect to any taxable year in which the individual is 
simultaneously eligible to participate in a broad-based foreign 
retirement plan and a qualified employer plan described in paragraph 
(a)(2) of this section. For purposes of this paragraph (a)(3)(iii), an 
individual is eligible to participate in a qualified employer plan if 
under the terms of the plan and without further amendment or action by 
the plan sponsor, the individual is eligible to make or receive 
contributions or accrue benefits under the plan (regardless of whether 
the individual has elected to participate in the plan).
    (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 (42 U.S.C. 433) with any foreign jurisdiction. In addition, the 
term nonqualified deferred compensation plan does not include a

[[Page 19279]]

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 foreign retirement plan. The term broad-based 
foreign retirement plan means a scheme, trust, arrangement, or plan 
(regardless of whether sponsored by a U.S. person) that is written and 
that, in the case of an employer-maintained plan, satisfies the 
following conditions:
    (A) The plan is nondiscriminatory insofar as the employees who, 
under the terms of the plan (alone or in combination with other 
comparable plans) and without further amendment or action by the 
employer, are eligible to make or receive contributions or accrue 
benefits under the plan other than earnings (regardless of whether the 
employee has elected to participate in the plan), are a wide range of 
employees, substantially all of whom are nonresident aliens, resident 
aliens classified as resident aliens solely under section 
7701(b)(1)(A)(ii) (and not section 7701(b)(1)(A)(i)), or bona fide 
residents of a possession (within the meaning of section 937(a)), 
including rank and file employees.
    (B) The plan (alone or in combination with other comparable plans) 
actually provides significant benefits for a substantial majority of 
such covered employees.
    (C) The benefits actually provided under the plan to such covered 
employees are nondiscriminatory.
    (D) The plan contains provisions or is the subject of tax law 
provisions or other legal restrictions that generally discourage 
employees from using plan benefits for purposes other than retirement 
or restrict access to plan benefits before separation from service, 
including (but not limited to), restricting in-service distributions 
except in events similar to an unforeseeable emergency (as defined in 
Sec.  1.409A-3(i)(3)(i)) or hardship (as defined for purposes of 
section 401(k)(2)(B)(i)(IV)), or for educational purposes or the 
purchase of a primary residence.
    (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 
non-employees 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). For purposes of the application of section 409A to a 
plan to which section 457 applies, a payment under the plan generally 
means the provision of cash or property to the service provider, 
provided that for purposes of the application of the short-term 
deferral rule set forth in paragraph (b)(4) of this section, the 
inclusion in income of an amount under section 457(f) is treated as a 
payment of the amount.
    (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, provided 
that for purposes of this paragraph, such disability pay and death 
benefits may be provided through insurance and the lifetime benefits 
payable under the plan are not treated as including the value of any 
taxable term life insurance coverage or taxable disability insurance 
coverage provided under the plan. 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 such that the 
benefits or reimbursements provided under such arrangement are not 
includible in income.
    (b) Deferral of compensation--(1) In general. Except as otherwise 
provided in paragraphs (b)(3) through (b)(12) 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, 
pursuant to the terms of the plan, is or may be payable to (or on 
behalf of) the service provider in a later taxable year. Such 
compensation is deferred compensation for purposes of section 409A, 
this section and Sec. Sec.  1.409A-2 through 1.409A-6. A legally 
binding right to an amount that will be excluded from income when and 
if received does not constitute a deferral of compensation, unless the 
service provider has received the right in exchange for, or has the 
right to exchange the right for, an amount that will be includible in 
income (other than due to participation in a cafeteria plan described 
in section 125). A service provider does not have a legally binding 
right to compensation to the extent 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 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 discretion to reduce or eliminate the 
compensation lacks substantive significance depends on all the relevant 
facts and circumstances. 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 a nondiscretionary, 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 another plan 
(including 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.

[[Page 19280]]

    (2) Earnings. References to the deferral of compensation or 
deferred compensation include references to earnings. When the right to 
earnings is specified under the terms of the plan, the legally binding 
right to earnings arises at the time of the deferral of the 
compensation to which the earnings relate. A plan may provide that the 
time and form of payment of earnings is treated separately from the 
time and form of payment of the underlying compensation, so that, 
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-3(e).
    (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 the plan under which a payment (as 
defined in Sec.  1.409A-2(b)(2)) is made does not provide for a 
deferred payment and the service provider actually or constructively 
receives such payment on or before the last day of the applicable 2\1/
2\ month period. The following rules apply for purposes of this 
paragraph (b)(4)(i):
    (A) The applicable 2\1/2\ month period is the period ending on the 
later of the 15th day of the third month following the end of the 
service provider's first taxable year in which the right to the payment 
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 right to the payment is no longer 
subject to a substantial risk of forfeiture.
    (B) A payment is treated as actually or constructively received if 
the payment is includible in income, including if the payment is 
includible in income under section 83, the economic benefit doctrine, 
section 402(b), or section 457(f).
    (C) A right to a payment 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 payment.
    (D) A plan provides for a deferred payment if the plan provides 
that any payment will be made or completed on or after any date, or 
upon or after the occurrence of any event, that will or may occur later 
than the end of the applicable 2\1/2\ month period, such as a 
separation from service, death, disability, change in control event, 
specified time or schedule of payment, or unforeseeable emergency, 
regardless of whether an amount is actually paid as a result of the 
occurrence of such a payment date or event during the applicable 2\1/2\ 
month period. If a plan provides that the service provider or service 
recipient may make an election under the plan (including an election 
under Sec.  1.409A-2(a)(4)) of a different payment date, schedule, or 
event, such right is disregarded for this purpose. In such cases, 
whether a plan provides for a deferred payment is determined based on 
the payment date, schedule, or event that would apply if no such 
election were made, except that if the plan would not provide for a 
deferred payment absent such an election, and the service provider or 
service recipient makes such an election, whether the plan provides for 
a deferred payment is determined based upon the payment date, schedule, 
or event that the service provider or service recipient in fact 
elected.
    (E) A stock right provides for a deferred payment if such right 
includes any provision pursuant to which the holder of the stock right 
will or may have the right to exercise the stock right after the 
applicable 2\1/2\ month period.
    (F) This paragraph (b)(4)(i) is applied separately to each payment 
(as defined in Sec.  1.409A-2(b)(2)) required to be made under a plan.
    (G) If a plan provides for a deferred payment with respect to part 
of a payment (for example a life annuity or a series of installment 
amounts treated as a single payment), the plan provides for a deferred 
payment with respect to the entire payment.
    (ii) Certain delayed payments. A payment that otherwise qualifies 
as a short-term deferral under paragraph (b)(4)(i) of this section but 
is made after 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 and, as of the date upon which the 
legally binding right to the compensation arose, such impracticability 
was unforeseeable, or the taxpayer establishes that making the payment 
by the end of the applicable 2\1/2\ month period would have jeopardized 
the ability of the service recipient to continue as a going concern, 
and provided further that the payment is made as soon as 
administratively practicable or as soon as the payment would no longer 
have such effect. 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. In addition, a payment 
that otherwise qualifies as a short-term deferral under paragraph 
(b)(4)(i) of this section but is made after the applicable 2\1/2\ month 
period may continue to qualify as a short-term deferral if the taxpayer 
establishes that the service recipient reasonably anticipated that the 
service recipient's deduction with respect to such payment otherwise 
would not be permitted by application of section 162(m), and, as of the 
date the legally binding right to the payment arose, a reasonable 
person would not have anticipated the application of section 162(m) at 
the time of the payment, and provided further that the payment is made 
as soon as reasonably practicable following the first date on which the 
service recipient anticipates or reasonably should anticipate that, if 
the payment were made on such date, the service recipient's deduction 
with respect to such payment would no longer be restricted due to the 
application of section 162(m). For additional rules applicable to 
certain transaction-based compensation, see Sec.  1.409A-
3(i)(5)(iv)(A).
    (iii) Examples. The following examples illustrate the provisions of 
this paragraph (b)(4). In these examples, except as otherwise noted, 
each employee and each employer has a calendar year taxable year and 
each employee is an individual who is employed by the specified 
employer.

    Example 1.  On November 1, 2008, Employer Z awards a bonus to 
Employee A such that Employee A has a legally binding right to the 
payment as of November 1, 2008, that is not subject to a substantial 
risk of forfeiture. The bonus plan does not provide for a payment 
date or a deferred payment. The bonus plan will not be considered to 
have provided for a deferral of compensation if the bonus is paid or 
made available to Employee A on or before March 15, 2009.

[[Page 19281]]

    Example 2.  Employer Y has a taxable year ending August 31. On 
November 1, 2008, Employer Y awards a bonus to Employee B so that 
Employee B has a legally binding right to the payment as of November 
1, 2008, that is not subject to a substantial risk of forfeiture. 
The bonus plan does not provide for a payment date or a deferred 
payment. The bonus plan will not be considered to have provided for 
a deferral of compensation if the bonus is paid or made available to 
Employee B on or before November 15, 2009.
    Example 3.  On November 1, 2008, Employer X awards a bonus to 
Employee C such that Employee C has a legally binding right to the 
payment as of November 1, 2008. Under the bonus plan, Employee C 
will forfeit the bonus unless Employee C continues performing 
services through December 31, 2010. The right to the payment is 
subject to a substantial risk of forfeiture through December 31, 
2010. Employee C has the right to make a written election not later 
than December 31, 2009, to receive the bonus on or after December 
31, 2015, but Employee C does not make such election. The bonus plan 
does not provide for a default payment date or a deferred payment in 
the absence of an election by Employee C. The bonus plan will not be 
considered to have provided for a deferral of compensation if the 
bonus is paid or made available to Employee C on or before March 15, 
2011 (and generally any payment before June 1, 2011 would constitute 
an impermissible acceleration of a payment).
    Example 4.  On November 1, 2008, Employer W awards a bonus to 
Employee D such that Employee D has a legally binding right to the 
payment as of November 1, 2008. Under the bonus plan, the bonus will 
be determined based on services performed during the period from 
January 1, 2009 through December 31, 2010. The bonus is scheduled to 
be paid as a lump sum payment on February 15, 2011. Under the bonus 
plan, Employee D will forfeit the bonus unless Employee D continues 
performing services through the scheduled payment date (February 15, 
2011). Provided that at all times before the scheduled payment date 
Employee D is required to continue to perform services to retain the 
right to the bonus, and the bonus is paid on or before March 15, 
2012, the bonus plan will not be considered to have provided for a 
deferral of compensation.
    Example 5.  On November 1, 2008, Employer V awards a bonus to 
Employee E such that Employee E has a legally binding right to the 
payment as of November 1, 2008. Under the bonus plan, Employee E 
will forfeit the bonus unless Employee E continues performing 
services through December 31, 2010. Under the bonus plan, the bonus 
is scheduled to be paid as a lump sum payment on July 1, 2011. By 
specifying a payment date after the applicable 2\1/2\ month period, 
the bonus plan provides for a deferred payment. The bonus plan 
provides for a deferral of compensation, and will not qualify as a 
short-term deferral regardless of whether the bonus is paid or made 
available on or before March 15, 2011.
    Example 6.  On November 1, 2008, Employer U awards a bonus to 
Employee F such that Employee F has a legally binding right to the 
payment as of November 1, 2008, that is not subject to a substantial 
risk of forfeiture. The bonus plan provides for a lump sum payment 
upon Employee F's separation from service. Because the separation 
from service is an event that may occur after the applicable 2\1/2\ 
month period, the bonus plan provides for a deferred payment and 
therefore provides for a deferral of compensation. Accordingly, the 
bonus plan will not qualify as a short-term deferral regardless of 
whether Employee F separates from service and the bonus is paid or 
made available on or before March 15, 2009.
    Example 7.  On November 1, 2008, Employer T grants Employee G a 
legally binding right to the payment of a life annuity with the 
first annuity payment on November 1, 2013, provided that Employee G 
continues performing services for Employer T continuously through 
November 1, 2013. Because the life annuity is treated as a single 
payment, and because all payments of the life annuity may not occur 
during the applicable 2\1/2\ month period, the plan provides for a 
deferred payment and none of the amounts payable under the annuity 
will qualify as a short-term deferral, so that section 409A applies 
to all amounts that are payable under the plan.
    Example 8.  On November 1, 2008, Employer S grants Employee H a 
stock right providing for an exercise price less than the fair 
market value of the underlying stock on November 1, 2008. The stock 
right is subject to a substantial risk of forfeiture requiring 
services through November 1, 2010. The stock right becomes 
exercisable when the substantial risk of forfeiture lapses and 
expires on November 1, 2013. Employee H continues providing services 
through November 1, 2010, at which time the substantial risk of 
forfeiture lapses. The stock right provides for a deferred payment 
and will not qualify as a short-term deferral regardless of whether 
Employee H exercises the stock right on or before March 15, 2011.

    (5) Stock options, stock appreciation rights, and other equity-
based compensation--(i) Stock rights--(A) Nonstatutory stock options 
not providing for the deferral of compensation. An option to purchase 
service recipient stock does not provide for a deferral of compensation 
if--
    (1) 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 the following:
    (i) The exercise or disposition of the option under Sec.  1.83-7.
    (ii) 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 based on the appreciation in 
value of a specified number of shares of service recipient stock 
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 excess of 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 over an amount specified 
on the date of grant of the stock appreciation right (the stock 
appreciation right exercise price), 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 exercise price 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 generally will 
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 excess of 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

[[Page 19282]]

over 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, the grant of the stock appreciation right 
generally will 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 provides a right other than the right to receive cash or stock on 
the date of exercise and such additional right would otherwise allow 
compensation to be deferred beyond the date of exercise, 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. For purposes of this paragraph (b)(5)(i), 
the right, directly or indirectly contingent upon the exercise of a 
stock right, to receive an amount equal to all or part of the dividends 
or other distributions (other than stock dividends described in 
paragraph (b)(5)(v)(H) of this section) 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 right 
to be subject to section 409A). A plan providing a right to dividends 
or other distributions declared and paid on the number of shares 
underlying a stock right, the payment of which is not contingent upon, 
or otherwise payable on, the exercise of the stock right, may provide 
for a deferral of compensation, but the existence of the right to 
receive such an amount will not be treated as a reduction to the 
exercise price of (or an increase to the compensation payable under) 
the stock right. Thus, a right to such dividends or distributions that 
is not contingent, directly or indirectly, upon the exercise of a stock 
right will not cause the related stock right to fail to satisfy the 
requirements of the exclusion from the definition of a deferral of 
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, the exclusion for 
statutory stock options under 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 for purposes 
of this paragraph (b) as if it had been a nonstatutory stock option 
from the date of the original grant. Accordingly, if such modification, 
extension, or renewal of the stock option would have been treated as 
the grant of a new option or as causing the option to have had a 
deferral feature from the date of grant under paragraph (b)(5)(v) of 
this section, the modification, extension, or renewal of the stock 
option is treated as the grant of a new option or as causing the option 
to have had a deferral feature from the date of grant for purposes of 
this paragraph (b)(5).
    (iii) Service recipient stock--(A) In general. Except as otherwise 
provided in paragraphs (b)(5)(iii)(B), (C), and (D) of this section, 
the term service recipient stock means a class of stock that, as of the 
date of grant, is common stock for purposes of section 305 and the 
regulations thereunder of a corporation that is an eligible issuer of 
service recipient stock (as defined in paragraph (b)(5)(iii)(E) of this 
section). Notwithstanding the foregoing, the term service recipient 
stock does not include a class of stock that has any preference as to 
distributions other than distributions of service recipient stock and 
distributions in liquidation of the issuer. The term service recipient 
stock also does not include any stock that is subject to a mandatory 
repurchase obligation (other than a right of first refusal), or a put 
or call right that is not a lapse restriction as defined in Sec.  1.83-
3(i), if the stock price under such right or obligation 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. An American 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 recipient stock.
    (C) Mutual company units. 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 or association. 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 such fixed percentage. 
For example, an appreciation right based on the appreciation of 10 
mutual company units, where each unit is defined as one 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), the shares of 
which are not readily tradable on an established securities market.
    (D) Other entities. An interest in an entity other than a 
corporation or non-stock mutual company or association may constitute 
service recipient stock 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).
    (E) Eligible issuer of service recipient stock--(1) In general. The 
term eligible issuer of service recipient stock means only the 
corporation for which the service provider provides direct services on 
the date of grant of the stock right (if the entity receiving such 
services is a corporation), and any corporation in a chain of 
corporations or other entities in which each corporation or other 
entity has a controlling interest in another corporation or other 
entity in the chain, ending with the corporation or other entity that 
has a controlling interest in the corporation or other entity for which 
the service provider provides direct services on the date of grant of 
the stock right. For this purpose, the term controlling interest has 
the same meaning as provided in Sec.  1.414(c)-2(b)(2)(i), provided 
that the language ``at least 50 percent'' is used instead of ``at least 
80 percent'' each place it appears in Sec.  1.414(c)-2(b)(2)(i). 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 controlling interest has the same meaning as 
provided in Sec.  1.414(c)-

[[Page 19283]]

2(b)(2)(i), provided that the language ``at least 20 percent'' is used 
instead of ``at least 80 percent'' each place it appears in Sec.  
1.414(c)-2(b)(2)(i). For purposes of determining ownership of an 
interest in an organization, the rules of Sec. Sec.  1.414(c)-3 and 
1.414(c)-4 apply. The determination of whether a grant is based on 
legitimate business criteria is based on the facts and circumstances, 
focusing primarily on whether there is a sufficient nexus between the 
service provider and the issuer of the stock right so that the grant 
serves a legitimate non-tax business purpose other than simply 
providing compensation to the service provider that is excluded from 
the requirements of section 409A. For example, stock of a corporation 
that owns an interest in a joint venture involving an operating 
business, used with respect to stock rights granted to service 
providers of the joint venture who are former service providers of such 
corporation, generally will constitute use of service recipient stock 
based upon legitimate business criteria, and therefore could constitute 
service recipient stock with respect to such service providers if the 
corporation owns at least 20 percent of the joint venture and the other 
requirements of this paragraph (b)(5)(iii) are met. Similarly, the 
legitimate business criteria requirement generally would be met if the 
corporate venturer issued such a right to an employee of the joint 
venture who it reasonably expected would in the future become an 
employee of the corporate venturer. However, where a service provider 
has no real nexus with a corporate venturer, such as generally happens 
when the corporate venturer is a passive investor in the service 
recipient joint venture, a stock right issued to that employee on the 
investor corporation's stock generally would not be based upon 
legitimate business criteria. Similarly, where a corporation holds only 
a minority interest in an entity that in turn holds a minority interest 
in the entity for which the service provider performs services, such 
that the corporation holds only an insubstantial indirect interest in 
the entity receiving the services, legitimate business criteria 
generally would not exist for issuing a stock right on the 
corporation's stock to the service provider.
    (2) Investment vehicles. Notwithstanding the provisions of 
paragraph (b)(5)(iii)(E)(1) of this section, except as to a service 
provider providing services directly to such corporation, for purposes 
of this paragraph (b)(5), an eligible issuer of service recipient stock 
does not include any corporation whose primary purpose is to serve as 
an investment vehicle with respect to the corporation's minority 
ownership interests in entities other than the service recipient.
    (3) Corporate structures established or transactions undertaken for 
purposes of avoiding coverage under section 409A. Notwithstanding the 
provisions of paragraph (b)(5)(iii)(E)(1) of this section, an eligible 
issuer of service recipient stock does not include any corporation 
within a group of entities treated as a single service recipient if a 
purpose of the establishment of the structure of the ownership, or a 
purpose of a significant transaction between or among two or more 
entities comprising a single service recipient, is to provide deferred 
compensation not subject to the application of section 409A. If an 
entity becomes a member of a group of corporations or other entities 
treated as a single service recipient, and the primary source of income 
or value of such entity arises from the provision of management 
services to other members of the service recipient group, it is 
presumed that such structure was established for purposes of avoiding 
the application of section 409A if any stock rights are issued with 
respect to such entity.
    (4) 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 this section and 
Sec. Sec.  1.409A-2 through 1.409A-6, the stock underlying the stock 
right that replaced 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 if such underlying 
stock otherwise satisfies the requirements of paragraph (b)(5)(iii)(A) 
of this section. For example, if by reason of a spinoff transaction 
(under which the stock of a subsidiary corporation is distributed to 
the stockholders of a distributing corporation), a 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 (each otherwise 
satisfying the requirements of paragraph (b)(5)(iii)(A) of this 
section), 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.
    (iv) Determination of the fair market value of service recipient 
stock--(A) Stock readily tradable on an established securities market. 
For purposes of paragraph (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, the arithmetic mean of the high and low prices on the trading 
day before or the trading day of the grant, or any other reasonable 
method using actual transactions in such stock as reported by such 
market. The determination of fair market value also may be determined 
using an average selling price during a specified period that is within 
30 days before or 30 days after the applicable valuation date, provided 
that the program under which the stock right is granted, including a 
program with a single participant, must irrevocably specify the 
commitment to grant the stock right with an exercise price set using 
such an average selling price before the beginning of the specified 
period. For this purpose, the term average selling price refers to the 
arithmetic mean of such selling prices on all trading days during the 
specified period, or the average of such prices over the specified 
period weighted based on the volume of trading of such stock on each 
trading day during such specified period. To satisfy this requirement, 
the service recipient must designate the recipient of the stock right, 
the number and class of shares of stock that are subject to the stock 
right, and the method for determining the exercise price including the 
period over which the averaging will occur, before the beginning of the 
specified averaging period. Notwithstanding the forgoing provisions of 
this paragraph (b)(5)(iv)(A), where applicable foreign law requires 
that a compensatory stock right be priced based upon a specific price 
averaging method and period, a stock right granted in accordance with 
such applicable foreign law will be treated as meeting the requirements 
of this paragraph (b)(5)(iv)(A), provided that the averaging period 
does not exceed 30 days.
    (B) Stock not readily tradable on an established securities 
market--(1) In general. For purposes of paragraph

[[Page 19284]]

(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 
method. The determination 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 anticipated 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 the stock 
of which is to be valued, the value of which can be readily determined 
through nondiscretionary, objective means (such as through trading 
prices on an established securities market or an amount paid in an 
arm's length private transaction), recent arm's length transactions 
involving the sale or transfer of such stock or equity interests, 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 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 as of a date that is no more than 12 months before the 
relevant transaction to which the valuation is applied (for example, 
the date of grant 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 any substantially 
similar class of stock) to the issuer or any person that owns stock 
possessing more than 10 percent of the total combined voting power of 
all classes of stock of the issuer (applying the stock attribution 
rules of Sec.  1.424-1(d)), other than an arm's length transaction 
involving the sale of all or substantially all of the outstanding stock 
of the issuer, 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)(iv)(B)(1) of this section, of illiquid 
stock of a start-up corporation. For this purpose, illiquid stock of a 
start-up corporation means service recipient stock of a corporation 
that has no material 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, call, or other 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(i)(5)(v) or Sec.  1.409A-3(i)(5)(vii) within the 90 days following 
the action to which the valuation is applied, or make a public offering 
of securities within the 180 days following the action to which the 
valuation is applied. 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 that the corporation reasonably determines is 
qualified to perform such a valuation based on the person's or 
persons'' significant knowledge, experience, education, or training. 
Generally, a person will be qualified to perform such a valuation if a 
reasonable individual, upon being apprised of such knowledge, 
experience, education, and training, would reasonably rely on the 
advice of such person with respect to valuation in deciding whether to 
accept an offer to purchase or sell the stock being valued. For this 
purpose, significant experience generally means at least five years of 
relevant experience in business valuation or appraisal, financial 
accounting, investment banking, private equity, secured lending, or 
other comparable experience in the line of business or industry in 
which the service recipient operates.
    (3) Use of alternative methods. For purposes of this paragraph 
(b)(5), a different valuation method may be used for each separate 
action for which a valuation is relevant, provided that a single 
valuation method is used for each separate action and, once used, may 
not retroactively be altered. For example, one valuation method may be 
used to establish the exercise price of a stock option, and a different 
valuation method may be used to determine the value at the date of the 
repurchase of stock pursuant to a put or call right. However, once an 
exercise price or amount to be paid has been established, the exercise 
price or amount to be paid may not be changed through the retroactive 
use of another valuation method. In addition, notwithstanding the 
foregoing, where after the date of grant, but before the date of 
exercise or transfer, of the stock right, the service recipient stock 
to which the stock right relates becomes readily tradable on an 
established securities market, the service recipient must use the 
valuation method set forth in paragraph (b)(5)(iv)(A) of this section

[[Page 19285]]

for purposes of determining the payment at the date of exercise or the 
purchase of the stock, as applicable.
    (v) Modifications, extensions, substitutions, and assumptions of 
stock rights--(A) Treatment of modified and extended stock rights. A 
modification of the terms of a stock right within the meaning of 
paragraph (b)(5)(v)(B) of this section is considered to be the grant 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. If there is an 
extension of a stock right (within the meaning of paragraph 
(b)(5)(v)(C) of this section), the stock right is treated as having had 
an additional deferral feature from the original date of grant of the 
stock right, and therefore will be treated as a plan providing for the 
deferral of compensation from the original grant date for purposes of 
this paragraph (b).
    (B) Modification in general. Except as otherwise provided in 
paragraph (b)(5)(v) of this section, the term modification means any 
change in the terms of the 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 stock right) that may provide the 
holder of the stock right with a direct or indirect reduction in the 
exercise price of the stock right regardless of whether the holder in 
fact benefits from the change in terms. 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 the exercise 
price or the 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--(1) In general. An extension of a stock right 
refers to the provision to the holder of an additional period of time 
within which to exercise the stock right beyond the time originally 
prescribed under the terms of the stock right, the conversion or 
exchange of a stock right for a legally binding right to compensation 
in a future taxable year, or the addition of any feature for the 
deferral of compensation not permitted in paragraph (b)(5)(i)(A)(3) of 
this section (in the case of a stock option) or not permitted in 
paragraph (b)(5)(i)(B)(3) of this section (in the case of a stock 
appreciation right) to the terms of the stock right, other than at a 
time when the exercise price of the stock right equals or exceeds the 
fair market value of the service recipient stock that could be 
purchased (in the case of an option) or the fair market value of the 
service recipient stock used to determine the payment to the service 
provider (in the case of a stock appreciation right), and includes a 
renewal of such right that has such effect. It is not an extension if 
the exercise period of a stock right is extended to a date no later 
than the earlier of the latest date upon which the stock right could 
have expired by its original terms under any circumstances or the 10th 
anniversary of the original date of grant of the stock right. If the 
exercise period of a stock right is extended at a time when the 
exercise price of the stock right equals or exceeds the fair market 
value of the service recipient stock that could be purchased (in the 
case of an option) or the fair market value of the service recipient 
stock used to determine the payment to the service provider (in the 
case of a stock appreciation right), it is not an extension of the 
original stock right. Instead, in such a case, the original stock right 
is treated as modified rather than extended and a new stock right is 
treated as having been granted for purposes of this section. In 
addition, it is not an extension of a stock right if the expiration of 
the stock right is tolled while the holder cannot exercise the stock 
right because such an exercise would violate an applicable Federal, 
state, local, or foreign law, or would jeopardize the ability of the 
service recipient to continue as a going concern, 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 an applicable Federal, state, local, and foreign laws or 
would first no longer jeopardize the ability of the service recipient 
to continue as a going concern. For this purpose, a provision of 
foreign law shall be considered applicable only to foreign earned 
income (as defined under section 911(b)(1) without regard to section 
911(b)(1)(B)(iv) and without regard to the requirement that the income 
be attributable to services performed during the period described in 
section 911(d)(1)(A) or (B)) from sources within the foreign country 
that promulgated such law.
    (2) Certain extensions before April 10, 2007. An extension of a 
stock right before April 10, 2007 solely in order to provide the holder 
of such stock right an additional period of time beyond the time 
originally prescribed under the terms of such stock right within which 
to exercise the stock right is disregarded for purposes of applying the 
rules contained in paragraph (b)(5)(v)(C)(1) of this section. For 
purposes of applying the rules contained in paragraph (b)(5)(v)(C)(1) 
of this section on and after April 10, 2007, such a stock right is 
treated as having specified at the date of grant the time within which 
to exercise such stock right that was prescribed under the terms of 
such stock right in effect on April 10, 2007. Nothing in this paragraph 
(b)(5)(v)(C)(2) affects any other action treated as the extension of a 
stock right, including the addition of a deferral feature.
    (3) Examples. The following examples illustrate the provisions of 
this paragraph (b)(5)(v)(C). In the examples, each employee is an 
individual employed by the specified employer, and each employee and 
each employer has a calendar year taxable year.

    Example 1. On July 1, 2009, Employer Z grants Employee A a 
nonstatutory stock option that does not provide for the deferral of 
compensation in accordance with paragraph (b)(5)(i)(A) of this 
section. The terms of the nonstatutory stock option provide that the 
exercise period of the stock option expires on the earlier of July 
1, 2019, or 3 months after Employee A's separation from service. On 
July 1, 2011, Employee A separates from service. On the same day, 
Employee A and Employer Z change the exercise period of the option 
so that it expires on July 1, 2013. Because the exercise period of 
the stock right is not extended beyond July 1, 2019, the change is 
not an extension for purposes of this paragraph (b)(5)(v)(C).
    Example 2. The facts are the same as in Example 1 except that 
Employee A separates from service on July 1, 2018, and on the same 
day, Employee A and Employer Z change the exercise period of the 
option so that it expires on July 1, 2020. As of July 1, 2018, the 
fair market value of the underlying stock exceeds the exercise 
price. Because the exercise period of the stock right is extended 
beyond July 1, 2019, the change is an extension for purposes of this 
paragraph (b)(5)(v)(C).
    Example 3. The facts are the same as in Example 2 except that as 
of July 1, 2018, the fair market value of the underlying stock is 
less than the exercise price of the option. Because the exercise 
period of the stock right is extended at a time when the fair market 
value of the underlying stock is less than the exercise price, the 
change is not an extension for purposes of this paragraph 
(b)(5)(v)(C) and the change is treated as a modification of the 
option, resulting in the extension of the exercise period being 
treated as the grant of a new option on July 1, 2018.
    Example 4. On July 1, 2009, Employer Y grants to Employee B a 
stock appreciation

[[Page 19286]]

right with respect to 200 shares of Employer Y common stock that 
does not provide for the deferral of compensation in accordance with 
paragraph (b)(5)(i)(B) of this section. Upon exercise of the stock 
appreciation right, Employee B is entitled to receive the excess of 
the fair market value of a share of Employer Y common stock on the 
date of exercise over $100 (the fair market value of a share of 
Employer Y common stock on July 1, 2009), multiplied by the number 
of shares with respect to which Employee B is exercising the right. 
The exercise period of the right expires on the earlier of July 1, 
2019, or 3 months after Employee B separates from service. Employee 
B cannot exercise the stock appreciation right with respect to more 
than 100 shares unless Employee B continues to be employed by 
Employer Y through June 30, 2014. On July 1, 2011, when the fair 
market value of a share of Employer Y common stock is $200, Employee 
B and Employer Y amend the stock appreciation right to provide that 
the right will be exercisable only during calendar year 2018, except 
that before January 1, 2017, Employee B may elect to designate 
calendar year 2023 or any subsequent calendar year before 2033 as 
the year in which the right will be exercisable. The amendment 
constitutes an extension of the stock appreciation right under 
paragraph (b)(5)(v)(C)(1) of this section. Under paragraph 
(b)(5)(v)(A) of this section, the stock appreciation right is 
treated as having had an additional deferral feature from the 
original date of grant (July 1, 2009) of the right, and therefore is 
treated as a plan providing for the deferral of compensation from 
that date. During the period from July 1, 2009, through June 30, 
2011, the provisions of the stock appreciation right relating to the 
time and form of payment did not satisfy the requirements of Sec.  
1.409A-3(a). Therefore, the stock appreciation right provides for a 
deferral of compensation that does not comply with section 409A.

    (D) Substitutions and assumptions of stock rights by reason of a 
corporate transaction. If the requirements of Sec.  1.424-1 (without 
regard to the requirement described in Sec.  1.424-1(a)(2) that an 
eligible corporation be the employer of the optionee) would be met if 
the stock right were a statutory option, the substitution of a new 
stock right pursuant to a corporate transaction (as defined in Sec.  
1.424-1(a)(3)) 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 this section and Sec. Sec.  1.409A-2 through 
1.409A-6. 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) related to the fair market value of the stock may be satisfied 
by--
    (1) Using the last sale before or the first sale after the 
specified date as of which such valuation is being made, the closing 
price on the last trading day before or the trading day of a specified 
date, the arithmetic mean of the high and low prices on the last 
trading day before or the trading day of such specified date, or any 
other reasonable method using actual transactions in such stock as 
reported by such market on a specified date, for the stock of the 
distributing corporation and the stock distributed in the transaction, 
provided the specified date is designated before such specified date, 
and such specified date is not more than 60 days after the transaction;
    (2) Using the arithmetic mean of such market prices on trading days 
during a specified period designated before the beginning of such 
specified period, where such specified period is not longer than 30 
days and ends no later than 60 days after the transaction; or
    (3) Using an average of such prices during such prespecified period 
weighted based on the volume of trading of such stock on each trading 
day during such prespecified period.
    (E) Acceleration of date when exercisable. Although with respect to 
a stock right not immediately exercisable in full, a change in the 
terms of the right solely to accelerate or delay, within the original 
term of the stock right, the time at which the stock right (or any 
portion of such stock right) may be exercised is not a modification for 
purposes of this section, with respect to a stock right subject to 
section 409A, such an acceleration may constitute an impermissible 
acceleration of a payment date under Sec.  1.409A-3(j) or a subsequent 
deferral under Sec.  1.409A-2(b).
    (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 or extension, then the addition of such 
discretion is a modification or extension 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 there is no modification of 
the stock right 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. A 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) 
is not considered a modification or extension 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 
service provider's taxable year during which such change occurred. 
Thus, for example, if the terms of a stock right granted to an 
individual employee with a calendar year taxable year are changed on 
March 1 in a manner that would result in an extension of the stock 
right, and the change is rescinded on November 1 of the same year, and 
the stock right is not exercised before the change is rescinded, the 
stock right is not considered extended under this paragraph (b)(5)(v).
    (J) Successive modifications and extensions. The rules of this 
paragraph (b)(5)(v) apply as well to successive modifications and 
extensions.
    (K) Modifications and extensions in effect on October 23, 2004. For 
purposes of the application of section 409A and

[[Page 19287]]

these regulations to a stock right, if a legally binding right to a 
modification or extension of such stock right existed on October 23, 
2004, such modification or extension is disregarded, and the stock 
right is treated as if granted with the terms and conditions in effect 
on October 23, 2004.
    (vi) Meaning and use of certain terms--(A) Option. The term option 
means the right or privilege of an individual to purchase stock from a 
corporation by virtue of an offer of the corporation continuing for a 
stated period of time, whether or not irrevocable, to sell such stock 
at a price determined under paragraph (b)(5)(vi)(D) of this section, 
such individual being under no obligation to purchase. While no 
particular form of words is necessary, the option must express an offer 
to sell at the option price, the maximum number of shares purchasable 
under the option, and the period of time during which the offer remains 
open. The term option includes a warrant that meets the requirements of 
this paragraph (b)(5)(vi)(A). An option may be granted as part of or in 
conjunction with an employee stock purchase plan or subscription 
contract. An option must be in writing (in paper or electronic form) 
provided that such writing is adequate to establish an option right or 
privilege that is enforceable under applicable law.
    (B) Date of grant of option. (1) The language the date of grant of 
the option, and similar phrases, refer to the date when the granting 
corporation completes the corporate action necessary to create the 
legally binding right constituting the option. A corporate action 
creating the legally binding right constituting the option is not 
considered complete until the date on which the maximum number of 
shares that can be purchased under the option and the minimum exercise 
price are fixed or determinable, and the class of underlying stock and 
the identity of the service provider is designated. Ordinarily, if the 
corporate action provides for an immediate offer of stock for sale to a 
service provider, or provides for a particular date on which such offer 
is to be made, the date of the granting of the option is the date of 
such corporate action if the offer is to be made immediately, or the 
date provided as the date of the offer, as the case may be. However, an 
unreasonable delay in the giving of notice of such offer to the service 
provider will be taken into account as indicating that the corporation 
provided that the offer was to be made at the subsequent date on which 
such notice is given.
    (2) If the corporation imposes a condition on the granting of an 
option (as distinguished from a condition governing the exercise of the 
option), such condition generally will be given effect in accordance 
with the intent of the corporation. However, if the grant of an option 
is subject to approval by stockholders, the date of grant of the option 
will be determined as if the option had not been subject to such 
approval. A condition that does not require corporate action, such as 
the approval of, or registration with, some regulatory or government 
agency, for example, a stock exchange or the Securities and Exchange 
Commission, is ordinarily considered a condition upon the exercise of 
the option unless the corporate action clearly indicates that the 
option is not to be granted until such condition has been satisfied.
    (3) In general, a condition imposed upon the exercise of an option 
will not operate to make ineffective the granting of the option. For 
example, on June 1, 2008, Corporation A grants to X, an employee, an 
option to purchase 5,000 shares of the corporation's common stock, 
exercisable by X on or after June 1, 2009, provided X is employed by 
the corporation on June 1, 2009, and provided that A's profits during 
the fiscal year preceding the year of exercise exceed $200,000. Such an 
option is granted to X on June 1, 2008, and will be treated as 
outstanding as of such date.
    (C) Stock. The term stock means capital stock of any class, 
including voting or nonvoting common or preferred stock. Except as 
otherwise provided, the term stock includes both treasury stock and 
stock of original issue. Special classes of stock authorized to be 
issued to and held by employees are within the scope of the term stock 
for this purpose, provided such stock otherwise possesses the rights 
and characteristics of capital stock.
    (D) Exercise price. The term exercise price means the consideration 
in cash or property that, pursuant to the terms of the option, is the 
price at which the stock subject to the option is purchased. The term 
exercise price does not include any amounts paid as interest under a 
deferred payment plan or treated as interest.
    (E) Exercise. The term exercise, when used in reference to an 
option, means the act of acceptance by the holder of the option of the 
offer to sell contained in the option. In general, the time of exercise 
is the time when there is a sale or a contract to sell between the 
corporation and the individual. A promise to pay the exercise price 
does not constitute an exercise of the option unless the holder of the 
option is subject to personal liability on such promise. An agreement 
or undertaking by the service provider to make payments under a stock 
purchase plan does not constitute the exercise of an option to the 
extent the payments made remain subject to withdrawal by or refund to 
the service provider.
    (F) Transfer. The term transfer, when used in reference to the 
transfer to an individual of a share of stock pursuant to the exercise 
of an option, means the transfer of ownership of such share, or the 
transfer of substantially all the rights of ownership. Such transfer 
must, within a reasonable time, be evidenced on the books of the 
corporation. A transfer may occur even if a share of stock is subject 
to a substantial risk of forfeiture or is not otherwise transferable 
immediately after the date of exercise. A transfer does not fail to 
occur merely because, under the terms of the arrangement, the 
individual may not dispose of the share for a specified period of time, 
or the share is subject to a right of first refusal or a right to 
acquire the share at the share's fair market value at the time of the 
sale.
    (G) Readily tradable. For purposes of this section and Sec. Sec.  
1.409A-2 through 1.409A-6, stock is treated as readily tradable if it 
is regularly quoted by brokers or dealers making a market in such 
stock.
    (H) Application to stock appreciation rights. For purposes of this 
section and Sec. Sec.  1.409A-2 through 1.409A-6, the definitions 
provided in paragraphs (b)(5)(vi)(A) through (G) of this section may be 
applied by analogy to the issuance of, exercise of, or payment upon the 
exercise of, a stock appreciation right.
    (6) Restricted property, section 402(b) trusts, and section 403(c) 
annuities--(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 by reason of the property being 
substantially nonvested (as defined in Sec.  1.83-3(b)), or is 
includible in income 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). In addition, for purposes of this paragraph (b), a 
right to compensation income that will be required to be included in 
income under section

[[Page 19288]]

402(b)(4)(A) is not a deferral of compensation.
    (ii) Promises to transfer property. A plan under which a service 
provider obtains a legally binding right to receive property in a 
future taxable year where the property will be substantially vested (as 
defined in Sec.  1.83-3(b)) at the time of transfer of the property may 
provide for the deferral of compensation and, accordingly, may 
constitute a nonqualified deferred compensation plan. A legally binding 
right to receive property in a future taxable year where the property 
will be substantially nonvested (as defined in Sec.  1.83-3(b)) at the 
time of transfer of the property will not provide for the deferral of 
compensation and, accordingly, will not constitute a nonqualified 
deferred compensation plan unless offered in conjunction with another 
legally binding right that constitutes a deferral of compensation.
    (7) Arrangements between partnerships and partners. [Reserved.]
    (8) Certain foreign plans--(i) Plans with respect to compensation 
covered by treaty or other international agreement. A plan in which a 
service provider participates does not provide for a deferral of 
compensation for purposes of this paragraph (b) to the extent that the 
compensation under the plan 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) Plans with respect to certain other compensation. A plan in 
which a service provider participates does not provide for a deferral 
of compensation for purposes of this paragraph (b) to the extent that 
compensation under the plan 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, the compensation would have been 
foreign earned income within the meaning of section 911(b)(1) (without 
regard to section 911(b)(1)(B)(iv)) if paid at such time, and the 
amount of such compensation was equal to or less than the excess (if 
any) of the maximum exclusion amount under section 911(b)(2)(D) for 
such taxable year over the amount of foreign earned income actually 
excluded 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.
    (D) The compensation would have been excludible from gross income 
under section 931 or section 933.
    (iii) Tax equalization agreements. Compensation paid under a tax 
equalization agreement does not provide for a deferral of compensation 
if payments made under such tax equalization agreement are made no 
later than the end of the second taxable year of the service provider 
beginning after the taxable year of the service provider in which the 
service provider's U.S. Federal income tax return is required to be 
filed (including any extensions) for the year to which the compensation 
subject to the tax equalization payment relates, or, if later, the 
second taxable year of the service provider beginning after the latest 
such taxable year in which the service provider's foreign tax return or 
payment is required to be filed or made for the year to which the 
compensation subject to the tax equalization payment relates. Where 
such payments arise due to an audit, litigation or similar proceeding, 
the right to the payments will not be treated as resulting in a 
deferral of compensation if the payments are scheduled and made in 
accordance with the provisions of Sec.  1.409A-3(i)(1)(v) (timing of 
tax gross-up payments). For purposes of this paragraph (b)(8)(iii), the 
term tax equalization agreement refers to an agreement, method, 
program, or other arrangement that provides payments intended to 
compensate the service provider for some or all of the excess of the 
taxes actually imposed by a foreign jurisdiction on the compensation 
paid 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, state, and local income tax, or some or all of the 
excess of the United States Federal, state, and local income tax 
actually imposed on the compensation paid by the service to the service 
provider over the taxes that would be imposed if the compensation were 
subject solely to taxes in the foreign jurisdiction, provided that the 
payment made under such agreement, method, program, or other 
arrangement may not exceed such excess and the amount necessary to 
compensate for the additional taxes on the amount paid under the 
agreement, method, program, or other arrangement.
    (iv) Certain limited deferrals of a nonresident alien. With respect 
to a nonresident alien, a foreign plan does not provide for a deferral 
of compensation if the amounts deferred under the foreign plan based 
upon services performed by the nonresident alien in the United States 
(including amounts deferred based upon service credits or compensation 
received due to services performed in the United States) do not exceed 
the applicable dollar amount under section 402(g)(1)(B) for the taxable 
year. If the amounts deferred under the foreign plan based upon the 
services performed by the nonresident alien in the United States exceed 
the applicable dollar amount, an amount of such deferrals equal to such 
amount is treated as not deferred under a nonqualified deferred 
compensation plan. For purposes of this paragraph (b)(8)(iv), the term 
foreign plan means a plan that, together with all substantially similar 
plans, is maintained by a service recipient for a substantial number of 
participants, 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)).
    (v) Additional foreign plans. A plan in which a service provider 
participates 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).
    (vi) Earnings. Earnings on compensation excluded from the 
definition of deferral of compensation pursuant to this paragraph 
(b)(8) are also not treated as a deferral of compensation.
    (9) Separation pay plans--(i) In general. A plan 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, paragraphs (b)(9)(ii), (iii), (iv), and (v) of this 
section provide rules concerning the extent to which certain separation 
pay plans do not provide for the deferral of compensation. The 
exceptions contained in paragraphs (b)(9)(ii), (iii),

[[Page 19289]]

(iv), and (v) of this section may be used in combination, such that 
compensation under a plan that would be excepted under one of those 
paragraphs may be treated as excepted under another of those 
paragraphs, so that other compensation under a plan may be treated as 
excepted under the first of such paragraphs. 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 plan. If a service provider 
receives a payment at separation from service and also has a legally 
binding right to an amount of deferred compensation that would be 
forfeited upon the separation from service, whether the payment acts as 
an acceleration of vesting and substitute payment for the amount of 
deferred compensation forfeited, or whether the deferred compensation 
is treated as forfeited and the amount paid is treated as a separate 
payment of current compensation, is determined based on the facts and 
circumstances, provided that, where the separation from service is 
voluntary, it is presumed that the payment results from an acceleration 
of vesting followed by a payment of the deferred compensation that is 
subject to section 409A. Accordingly, any change in the payment 
schedule to accelerate or defer the payments would be subject to the 
rules of section 409A. The presumption that a right to a payment is not 
a new right, but is instead a right substituted for a pre-existing 
forfeited right, may be rebutted by demonstrating that the service 
provider would have obtained the right to the payment regardless of the 
forfeiture of the nonvested right. A factor indicating that the service 
provider would have obtained a right to a payment regardless of the 
forfeiture of the nonvested right is that the amount to which the 
service provider obtains a right is materially less than an amount 
equal to the present value of the forfeited amount multiplied by a 
fraction, the numerator of which is the period of service the service 
provider actually completed, and the denominator of which is the full 
period of service the service provider would have been required to 
complete to receive the full amount of the payment. For example, where 
a service provider is entitled to a future payment only if the service 
provider completes three years of service and at the time of 
termination the service provider has completed one year of service, the 
presumption could be rebutted if the payment to the service provider is 
materially less than the present value of one-third of the nonvested 
amount. Another such factor is that the payment to the service provider 
is of a type customarily made to service providers who separate from 
service with the service recipient and do not forfeit nonvested rights 
to deferred compensation (for example, a payment of accrued but unused 
leave or a payment for a release of actual or potential claims).
    (ii) Collectively bargained separation pay plans. A separation pay 
plan does not provide for a deferral of compensation to the extent the 
plan is a collectively bargained separation pay plan that provides for 
separation pay only upon an involuntary separation from service or 
pursuant to a window program. Only the portion of the separation pay 
plan attributable to employees covered by a bona fide collective 
bargaining agreement is considered to be provided under a collectively 
bargained separation pay plan. A collectively bargained separation pay 
plan is a separation pay plan that meets the following conditions:
    (A) The separation pay plan 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 arm's 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 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 only upon an involuntary separation from service (as 
defined in paragraph (n) of this section) or pursuant to a window 
program does not provide for a deferral of compensation to the extent 
that the separation pay, or portion of the separation pay, provided 
under the plan meets the following requirements:
    (A) The separation pay (other than amounts described in paragraphs 
(b)(9)(iv) and (v) of this section) does not exceed two times the 
lesser of--
    (1) The sum of the service provider's annualized compensation based 
upon the annual rate of pay for services provided to the service 
recipient for the taxable year of the service provider preceding the 
taxable year of the service provider in which the service provider has 
a separation from service with such service recipient (adjusted for any 
increase during that year that was expected to continue indefinitely if 
the service provider had not separated from service); or
    (2) The maximum amount that may be taken into account under a 
qualified plan pursuant to section 401(a)(17) for the year in which the 
service provider has a separation from service.
    (B) The plan provides that the separation pay described in 
paragraph (b)(9)(iii)(A) of this section must be paid no later than the 
last day of the second taxable year of the service provider following 
the taxable year of the service provider in which occurs the separation 
from service.
    (iv) Foreign separation pay plans. A separation pay plan (including 
a plan providing payments upon a voluntary separation from service) 
does not provide for deferred compensation to the extent the plan 
provides for amounts of separation pay required to be provided under 
the applicable law of a foreign jurisdiction. For this purpose, a 
provision of foreign law shall be considered applicable only to foreign 
earned income (as defined under section 911(b)(1) without regard to 
section 911(b)(1)(B)(iv) and without regard to the requirement that the 
income be attributable to services performed during the period 
described in section 911(d)(1)(A) or (B)) from sources within the 
foreign country that promulgated such law.
    (v) Reimbursements and certain other separation payments--(A) In 
general. To the extent a separation pay plan (including a plan 
providing payments upon a voluntary separation from service) entitles a 
service provider to payment by the service recipient of reimbursements 
that are not otherwise excludible from gross income, for expenses that 
the service provider could otherwise 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

[[Page 19290]]

to the termination of services for the service recipient, such plan 
does not provide for a deferral of compensation to the extent such 
rights apply during a limited period of time (regardless of whether 
such rights extend beyond the limited period of time). For purposes of 
this paragraph (b)(9)(v)(A), the reimbursement of reasonable moving 
expenses includes the reimbursement of all or part of any loss the 
service provider actually incurs due to the sale of a primary residence 
in connection with a separation from service.
    (B) Medical benefits. To the extent a separation pay plan 
(including a plan providing payments due to a voluntary separation from 
service) entitles a service provider to reimbursement by the service 
recipient of payments of medical expenses incurred and paid by the 
service provider but not reimbursed by a person other than the service 
recipient 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 plan does not provide for a deferral of compensation to 
the extent such rights apply during the period of time during which the 
service provider would be entitled (or would, but for such plan, be 
entitled) to continuation coverage under a group health plan of the 
service recipient under section 4980B (COBRA) if the service provider 
elected such coverage and paid the applicable premiums.
    (C) 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, is 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)(v).
    (D) Limited payments. If not otherwise excluded, a taxpayer may 
treat a right or rights under a separation pay plan to a payment or 
payments as not providing for a deferral of compensation to the extent 
such payments in the aggregate do not exceed the applicable dollar 
amount under section 402(g)(1)(B) for the year of the separation from 
service.
    (E) Limited period of time. For purposes of paragraphs (b)(9)(v)(A) 
and (C) of this section, a limited period of time in which expenses may 
be incurred, or in which in-kind benefits may be provided by the 
service recipient or a third party that the service recipient will pay, 
does not include periods beyond the last day of the second taxable year 
of the service provider following the taxable year of the service 
provider in which the separation from service occurred, provided that 
the period during which the reimbursements for such expenses must be 
paid may not extend beyond the third taxable year of the service 
provider following the taxable year of the service provider in which 
the separation from service occurred.
    (vi) Window programs--definition. The term window program refers to 
a program established by a service recipient in connection with an 
impending separation from service to provide separation pay, where such 
program is made available by the service recipient for a limited period 
of time (no longer than 12 months) 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.
    (10) Certain indemnification and liability insurance plans. A plan 
in which a service provider participates does not provide for a 
deferral of compensation for purposes of this paragraph (b) to the 
extent that the plan provides (to the extent permissible under 
applicable law), for the indemnification of, or the purchase of an 
insurance policy providing for payments of, all or part of the expenses 
incurred or damages paid or payable by a service provider with respect 
to a bona fide claim against the service provider or service recipient, 
including amounts paid or payable by the service provider upon the 
settlement of a bona fide claim against the service provider or service 
recipient, where such claim is based on actions or failures to act by 
the service provider in his or her capacity as a service provider of 
the service recipient.
    (11) Legal settlements. An agreement to which a service provider is 
a party does not provide for a deferral of compensation for purposes of 
this paragraph (b) to the extent that the agreement provides for 
amounts paid as settlements or awards resolving bona fide legal claims 
based on wrongful termination, employment discrimination, the Fair 
Labor Standards Act, or worker's compensation statutes, including 
claims under applicable Federal, state, local, or foreign laws, or for 
reimbursements or payments of reasonable attorneys fees or other 
reasonable expenses incurred by the service provider related to such 
bona fide legal claims, regardless of whether such settlements, awards, 
or reimbursement or payment of expenses pursuant to such claims are 
treated as compensation or wages for Federal tax purposes. Whether the 
execution of a waiver of any or all of such types of claims indicates 
that the amounts are paid as an award or settlement of an actual bona 
fide claim for damages under applicable law is determined based on the 
facts and circumstances. This paragraph (b)(11) does not apply to any 
deferred amounts that did not arise as a result of an actual bona fide 
claim for damages under applicable law, such as amounts that would have 
been deferred or paid regardless of the existence of such claim, even 
if such amounts are paid or modified as part of a settlement or award 
resolving an actual bona fide claim. For this purpose, a provision of 
foreign law shall be considered applicable only to foreign earned 
income (as defined under section 911(b)(1) without regard to section 
911(b)(1)(B)(iv) and without regard to the requirement that the income 
be attributable to services performed during the period described in 
section 911(d)(1)(A) or (B)) from sources within the foreign country 
that promulgated such law.
    (12) Certain educational benefits. A plan in which a service 
provider participates does not provide for a deferral of compensation 
to the extent the plan provides for taxable educational benefits. For 
purposes of this paragraph (b)(12), the term educational benefits 
refers solely to benefits provided to a service provider, consisting 
solely of educational assistance for the education of the service 
provider, as defined in section 127(c) and the accompanying 
regulations, and does not refer to any benefits provided for the 
education of any other person, including any spouse,

[[Page 19291]]

child, or other family member of the service provider.
    (c) Plan--(1) In general. The term plan includes any agreement, 
method, program, or other arrangement, including an agreement, method, 
program, or other 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, program, or other arrangement may constitute a plan regardless 
of whether it is an employee benefit plan under section 3(3) of 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. For purposes of determining the terms of a plan, general 
provisions of the plan that purport to nullify noncompliant plan terms, 
or to supply any specific plan terms required by this section, Sec.  
1.409A-2 or Sec.  1.409A-3, are disregarded.
    (2) Plan aggregation rules--(i) In general. Except as otherwise 
provided, the following rules apply with respect to the application of 
this section and Sec. Sec.  1.409A-2 through 1.409A-6 to deferrals of 
compensation with respect to a service provider:
    (A) All deferrals of compensation at the election of that service 
provider under all plans of the service recipient that are account 
balance plans, except to the extent that the plan is described in 
paragraph (c)(2)(i)(D), (E), (F), (G), or (H) of this section, are 
treated as deferred under a single plan. For purposes of this 
paragraph, the term account balance plan means--
    (1) An agreement, method, program, or other arrangement that is an 
account balance plan as defined in Sec.  31.3121(v)(2)-1(c)(1)(ii)(A) 
of this chapter, including mandatorily bifurcating the agreement, 
method, program, or other arrangement in accordance with the rules 
provided in Sec.  31.3121(v)-1(c)(1)(iii)(B) of this chapter; or
    (2) An agreement, method, program, or other arrangement that would 
be described in paragraph (c)(2)(i)(A)(1) of this section if the 
service provider were an employee.
    (B) All deferrals of compensation other than at the election of 
that service provider, including deferrals reflecting matching by the 
service recipient with respect to amounts a service provider elects to 
defer, under all plans of the service recipient that are account 
balance plans, except to the extent the plan is described in paragraph 
(c)(2)(i)(D), (E), (F), (G), or (H) of this section, are treated as 
deferred under a single plan. For purposes of this paragraph 
(c)(2)(i)(B), the term ``account balance plan'' has the same meaning as 
provided in paragraph (c)(2)(i)(A) of this section.
    (C) All deferrals of compensation with respect to that service 
provider under all plans of the service recipient that are nonaccount 
balance plans, except to the extent such plan is described in paragraph 
(c)(2)(i)(D), (E), (F), (G), or (H) of this section, are treated as 
deferred under a single plan. For purposes of this paragraph 
(c)(2)(i)(C), the term nonaccount balance plan means--
    (1) An agreement, method, program, or other arrangement that is a 
nonaccount balance plan as defined in Sec.  31.3121(v)(2)-1(c)(2)(i) of 
this chapter, including mandatorily bifurcating the agreement, method, 
program, or other arrangement in accordance with the rules provided in 
Sec.  31.3121(v)-1(c)(1)(iii)(B) of this chapter; or
    (2) An agreement, method, program, or other arrangement that would 
be described in paragraph (c)(2)(i)(C)(1) of this section if the 
service provider were an employee.
    (D) All deferrals of compensation with respect to that service 
provider under all separation pay plans (as defined in paragraph (m) of 
this section) of the service recipient to the extent an amount deferred 
under the plans is not described in paragraph (c)(2)(i)(E) of this 
section and is payable solely upon an involuntary separation from 
service within the meaning of paragraph (n) of this section or as a 
result of participation in a window program, are treated as deferred 
under a single plan.
    (E) All deferrals of compensation with respect to that service 
provider under all plans of the service recipient to the extent such 
amounts deferred consist of rights to in-kind benefits or 
reimbursements of expenses, such as membership fees, or expenses 
related to aircraft or vehicle usage, to the extent that the right to 
the in-kind benefit or reimbursement, separately or in the aggregate, 
does not constitute a substantial portion of either the overall 
compensation earned by the service provider for performing services for 
the service recipient or the overall compensation received due to a 
separation from service, are treated as deferred under a single plan.
    (F) All deferrals of compensation with respect to that service 
provider under all plans of the service recipient to the extent that 
the taxation of such compensation is governed by Sec.  1.61-22 or Sec.  
1.7872-15 (split-dollar life insurance arrangements), or the taxation 
of such compensation would be governed by Sec.  1.61-22 or Sec.  
1.7872-15 but for the operation of Sec.  1.61-22(j) (effective date 
provisions), are treated as deferred under a single plan.
    (G) All deferrals of compensation with respect to that service 
provider under all agreements, methods, programs, or other arrangements 
of the service recipient to the extent the deferrals under the 
agreements, methods, programs, or other arrangements are deferrals of 
amounts that would be treated as modified foreign earned income 
(meaning foreign earned income as defined under section 911(b)(1) 
without regard to section 911(b)(1)(B)(iv) and without regard to the 
requirement that the income be attributable to services performed 
during the period described in section 911(d)(1)(A) or (B)) if paid to 
the service provider at the time the amount is first deferred, and 
provided further that substantially all the participants in such 
agreements, methods, programs, or other arrangements and any 
substantially similar agreements, methods, programs, or other 
arrangements are nonresident aliens and that the service provider does 
not participate in a substantially identical agreement, method, 
program, or other arrangement that does not meet the requirements of 
this paragraph (c)(2)(i)(G) (a domestic arrangement), are treated as 
deferred under a single plan.
    (H) All deferrals of compensation with respect to that service 
provider under all plans of the service provider to the extent such 
plans are stock rights (as defined in paragraph (c)(2)(l) of this 
section) subject to section 409A, are treated as deferred under a 
single plan.
    (I) All deferrals of compensation with respect to that service 
provider under all plans of the service recipient to the extent such 
plans are not described in paragraph (c)(2)(i)(A), (B), (C), (D), (E), 
(F), (G), or (H) of this section are treated as deferred under a single 
plan.
    (ii) Dual status. Agreements, methods, programs, and other 
arrangements in which a service provider participates are not 
aggregated with other agreements, methods, programs, and other 
arrangements to the extent the service provider participates in one set 
of agreements, methods, programs, and other arrangements due to status 
as an employee of the service recipient (employee arrangements) and 
another set of agreements, methods, programs, and other 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 independent contractor arrangement 
while providing services as an independent contractor, and then

[[Page 19292]]

becomes eligible for and defers amounts under a separate employee 
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 is a member of the board of directors 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 (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 arrangements 
providing benefits to non-employee directors. To the extent a plan in 
which an employee director participates is not substantially similar to 
arrangements in which non-employee directors participate, such plan is 
treated as an employee plan for purposes of this paragraph (c)(2). 
Director plans and independent contractor plans are aggregated for 
purposes of this paragraph (c)(2).
    (3) Establishment of plan--(i) In general. A plan does not satisfy 
the requirements of section 409A and this section and Sec. Sec.  
1.409A-2 through 1.409A-3 and Sec. Sec.  1.409A-5 through 1.409A-6, 
unless the plan is established and maintained by a service recipient in 
accordance with the requirements of this section, Sec. Sec.  1.409A-2 
through 1.409A-3 and Sec. Sec.  1.409A-5 through 1.409A-6. For purposes 
of this paragraph (c)(3), a plan 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. 
The material terms of the plan may be set forth in writing in one or 
more documents. For purposes of this paragraph (c)(3)(i), a plan 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 
plan include the amount (or the method or formula for determining the 
amount) of deferred compensation to be provided under the plan and the 
time and form of payment. Notwithstanding the foregoing, a plan will be 
deemed to be established as of the date the participant obtains a 
legally binding right to a deferral of compensation, provided that the 
plan is otherwise established under the rules of this paragraph 
(c)(3)(i) by the end of the taxable year of the service provider in 
which the legally binding right arises, or with respect to an amount 
not payable in the year immediately following the taxable year of the 
service provider in which the legally binding right arises (the 
subsequent year), the 15th day of the third month of the subsequent 
year.
    (ii) Initial deferral election provisions. If a plan provides a 
service provider or a service recipient with an initial deferral 
election, the plan satisfies the requirements of this paragraph (c)(3) 
if the plan sets forth in writing, on or before the date the applicable 
election is required to be irrevocable to satisfy the requirements of 
Sec.  1.409A-2(a), the conditions under which such election may be 
made.
    (iii) Subsequent deferral election provisions. If a plan permits a 
subsequent deferral election described in Sec.  1.409A-2(b), the plan 
satisfies the requirements of this paragraph (c)(3) if the plan sets 
forth in writing, on or before the date the election is required to be 
irrevocable to meet the requirements of Sec.  1.409A-2(b), the 
conditions under which such election may be made.
    (iv) Payment accelerations. Except as explicitly provided in Sec.  
1.409A-3, a plan is not required to set forth in writing the conditions 
under which a payment may be accelerated if such acceleration is 
permitted under Sec.  1.409A-3(j)(4).
    (v) Six-month delay for specified employees. A plan must provide 
that distributions to a specified employee 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 (the six-month delay rule). The six-month 
delay rule, required for payments due to the separation from service of 
a specified employee, must be written in the plan. A plan does not fail 
to be established and maintained merely because it does not contain the 
six-month delay rule when the service provider who has a right to 
compensation deferred under such plan is not a specified employee. 
However, such provision must be set forth in writing on or before the 
date such service provider first becomes a specified employee. In 
general, this means the provision must be set forth in writing on or 
before the specified employee effective date (as defined in paragraph 
(i)(3) of this section) for the first list of specified employees that 
includes such service provider.
    (vi) Plan amendments. In the case of an amendment that increases 
the amount deferred under a nonqualified deferred compensation plan, 
the plan is not considered established with respect to the additional 
amount deferred until the plan, as amended, is established in 
accordance with paragraph (c)(3)(i) of this section.
    (vii) Transition rule for written plan requirement. For purposes of 
this paragraph (c)(3), a legally enforceable unwritten plan that was 
adopted and effective before December 31, 2007, 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 plan are set forth in writing on or before December 31, 2007.
    (viii) Plan aggregation rules. The plan aggregation rules of 
paragraph (c)(2)(i) of this section do not apply to the requirements of 
this paragraph (c)(3). Accordingly, deferrals of compensation under an 
agreement, method, program, or other arrangement that fails to meet the 
requirements of section 409A solely due to a failure to meet the 
requirements of this paragraph (c)(3) are not aggregated with deferrals 
of compensation under other agreements, methods, programs, or 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 or equity value or completion of an initial public 
offering). For purposes of this paragraph (d), if a service provider's 
entitlement to the amount is conditioned on the occurrence of the 
service provider's involuntary separation from service without cause, 
the right is subject to a substantial risk of forfeiture if the 
possibility of forfeiture is substantial. 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 the 
performance of services. Except as provided with respect to certain 
transaction-based compensation under Sec.  1.409A-3(i)(5)(iv), the 
addition of any risk of

[[Page 19293]]

forfeiture after the legally binding right to the compensation arises, 
or any extension of a period during which compensation is subject to a 
risk of forfeiture, is disregarded for purposes of determining whether 
such compensation is subject to a substantial risk of forfeiture. 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 
present value of the amount subject to a substantial risk of forfeiture 
(disregarding, in determining the present value, the risk of 
forfeiture) is materially greater than the present value of the amount 
the recipient otherwise could have elected to receive absent such risk 
of forfeiture. For this purpose, compensation that the service provider 
would receive for continuing to perform services regardless of whether 
the service provider elected to receive the amount that is subject to a 
substantial risk of forfeiture is not taken into account in determining 
whether the present value of the right to the amount subject to a 
substantial risk of forfeiture is materially greater than the amount 
the recipient otherwise could have elected to receive absent such risk 
of forfeiture. For example, a salary deferral generally may not be made 
subject to a substantial risk of forfeiture. But, for example, where a 
bonus plan provides an election between a cash payment or restricted 
stock units with a present value that is materially greater 
(disregarding the risk of forfeiture) than the present value of such 
cash payment and 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 is not subject to a substantial 
risk of forfeiture at the earlier of the first date the holder may 
exercise the stock 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 is 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 
(where the service provider's ownership is determined with application 
of the attribution rules under section 318 if the service recipient is 
a corporation, or if the service recipient is an entity that is not a 
corporation, with application by analogy of the attribution rules under 
section 318), 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 the amount of which, 
or the entitlement to which, is contingent on the satisfaction of 
preestablished organizational or individual performance criteria 
relating to a performance period of at least 12 consecutive months. 
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. 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. In addition, except as provided in paragraph 
(e)(3) of this section, compensation is not performance-based 
compensation merely because the amount of such compensation is 
determined by reference to the value of the service recipient or the 
stock of the service recipient. Where a portion of an amount of 
compensation would qualify as performance-based compensation if the 
portion were the sole amount available under the plan, that portion of 
the award will not fail to qualify as performance-based compensation if 
that portion is designated separately or otherwise separately 
identifiable under the terms of the plan, and the amount of each 
portion is determined independently of the other. Compensation may be 
performance-based compensation where the amount will be paid regardless 
of satisfaction of the performance criteria due to the service 
provider's death, disability, or a change in control event (as defined 
in Sec.  1.409A-3(i)(5)(i)), provided that a payment made under such 
circumstances without regard to the satisfaction of the performance 
criteria will not constitute performance-based compensation. For 
purposes of this paragraph (e)(1), a disability refers to any medically 
determinable physical or mental impairment resulting in the service 
provider's inability to perform the duties of his or her position or 
any substantially similar position, where such impairment can be 
expected to result in death or can be expected to last

[[Page 19294]]

for a continuous period of not less than six months.
    (2) Payments based upon subjective performance criteria. The term 
performance-based compensation includes payments based upon subjective 
performance criteria, provided that--
    (i) The subjective performance criteria are bona fide and 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 
effective control of the participant service provider or such a family 
member, and no amount of the compensation of the person making such 
determination is effectively 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 a share of stock in the service recipient, after 
the date of a grant or award. However, compensation payable for a 
service period that is equal to the value of a predetermined number of 
shares of stock, and is variable only to the extent that the value of 
such shares appreciates or depreciates, generally will not be 
performance-based compensation. Notwithstanding the foregoing, the 
attainment of a prescribed value for the service recipient (or a 
portion thereof), or a share of stock in the service recipient, may be 
used as a preestablished organizational criterion for purposes of 
providing performance-based compensation, provided that the other 
requirements of paragraph (e)(1) of this section are satisfied. In 
addition, 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. A provision that allows a service provider to defer 
compensation that would be realized upon the exercise of a stock right 
generally constitutes an additional deferral feature 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 an individual, corporation, subchapter S corporation, 
partnership, personal service corporation (as defined in section 
269A(b)(1)), noncorporate entity that would be a personal service 
corporation if it were a corporation, qualified personal service 
corporation (as defined in section 448(d)(2)), and noncorporate entity 
that would be a qualified personal service corporation if it were a 
corporation, for any taxable year in which such individual, 
corporation, subchapter S corporation, partnership, or other entity 
accounts for gross income from the performance of services under the 
cash receipts and disbursements method of accounting. The term service 
provider generally includes a person who has separated from service (a 
former service provider).
    (2) Independent contractors--(i) In general. Except as otherwise 
provided in paragraph (f)(2)(iv) of this section, section 409A does not 
apply to an amount deferred under a plan between a service provider and 
service recipient with respect to a particular trade or business in 
which the service provider participates, including earnings credited to 
such deferred amount, 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 each of the following applies:
    (A) The service provider is actively engaged in the trade or 
business of providing services, other than as an employee or as a 
member of the board of directors of a corporation (or similar position 
with respect to an entity that is not 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)(2)(ii) of this section).
    (C) The service provider is not related to the service recipient, 
applying the definition of related person contained in paragraph 
(f)(2)(ii) of this section subject to the modification that the 
language ``20 percent'' is not used instead of ``50 percent'' each 
place ``50 percent'' appears in sections 267(b) and 707(b)(1).
    (ii) Related person. For purposes of this paragraph (f)(2), 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)(2)(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. In addition, in the case of a service provider who has been 
providing services in a trade or business for a period of not less than 
three consecutive years, for purposes of paragraph (f)(2)(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 in each of the prior three taxable years the 
revenues generated from the services provided to any service recipient 
or group of related service recipients during such prior taxable years 
did not exceed 70 percent of the total revenue generated by the service 
provider from the trade or business of providing such services and, at 
the time an amount is deferred, the service provider does not know or 
have reason to anticipate that the revenues generated from the services 
provided to any service recipient or group of related service 
recipients during the current year will exceed 70 percent of the total 
revenue generated by the service provider from the trade or business of 
providing such services.
    (iv) Management services. This paragraph (f)(2) does not apply to a 
service provider to the extent the service provider provides management 
services to a service recipient. For purposes of this paragraph 
(f)(2)(iv), the term management services means services

[[Page 19295]]

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 management or advisory services provided to a 
service recipient whose primary trade or business includes the 
investment of financial assets (including investments in real estate), 
such as a hedge fund or a real estate investment trust.
    (v) Services provided to related persons. Section 409A does not 
apply to an amount deferred under a plan that is a bona fide agreement, 
method, program, or other arrangement between a service provider and a 
related service recipient arising in the ordinary course of a 
particular trade or business in which the service provider is engaged 
to the extent that--
    (A) The service provider provides services to the service recipient 
as an independent contractor;
    (B) During the service provider's taxable year in which the amount 
is deferred, the service provider qualifies for the safe harbor 
provided in paragraph (f)(2)(iii) of this section with respect to such 
trade or business; and
    (C) Such agreement, method, program, or other arrangement and the 
practices thereunder (including billing and collection practices), are 
substantially similar to the agreements, methods, programs, or other 
arrangements and practices applicable to one or more unrelated service 
recipients to whom the service provider provides substantial services 
and that produce a majority of the total revenue that the service 
provider earns from the trade or business of providing such services 
during the taxable year.
    (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, if the service provider is an employee, the 
service recipient generally is the employer (including all persons 
treated as a single employer under section 414(b) or (c)). 
Notwithstanding the foregoing, section 409A applies to a plan that 
provides for the deferral of compensation, even if 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 employer 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 if the period of such leave does not exceed six months, or 
if longer, so long as the individual retains a right to reemployment 
with the service recipient under an applicable statute or by contract. 
For purposes of this paragraph (h)(1), a leave of absence constitutes a 
bona fide leave of absence only if there is a reasonable expectation 
that the employee will return to perform services for the employer. If 
the period of leave exceeds six months and the individual does not 
retain a right to reemployment under an applicable statute or by 
contract, the employment relationship is deemed to terminate on the 
first date immediately following such six-month period. Notwithstanding 
the foregoing, where a leave of absence is due to 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 six months, where such impairment causes the employee to 
be unable to perform the duties of his or her position of employment or 
any substantially similar position of employment, a 29-month period of 
absence may be substituted for such six-month period.
    (ii) Termination of employment. Whether a termination of employment 
has occurred is determined based on whether the facts and circumstances 
indicate that the employer and employee reasonably anticipated that no 
further services would be performed after a certain date or that the 
level of bona fide services the employee would perform after such date 
(whether as an employee or as an independent contractor) would 
permanently decrease to no more than 20 percent of the average level of 
bona fide services performed (whether as an employee or an independent 
contractor) over the immediately preceding 36-month period (or the full 
period of services to the employer if the employee has been providing 
services to the employer less than 36 months). Facts and circumstances 
to be considered in making this determination include, but are not 
limited to, whether the employee continues to be treated as an employee 
for other purposes (such as continuation of salary and participation in 
employee benefit programs), whether similarly situated service 
providers have been treated consistently, and whether the employee is 
permitted, and realistically available, to perform services for other 
service recipients in the same line of business. An employee is 
presumed to have separated from service where the level of bona fide 
services performed decreases to a level equal to 20 percent or less of 
the average level of services performed by the employee during the 
immediately preceding 36-month period. An employee will be presumed not 
to have separated from service where the level of bona fide services 
performed continues at a level that is 50 percent or more of the 
average level of service performed by the employee during the 
immediately preceding 36-month period. No presumption applies to a 
decrease in the level of bona fide services performed to a level that 
is more than 20 percent and less than 50 percent of the average level 
of bona fide services performed during the immediately preceding 36-
month period. The presumption is rebuttable by demonstrating that the 
employer and the employee reasonably anticipated that as of a certain 
date the level of bona fide services would be reduced permanently to a 
level less than or equal to 20 percent of the average level of bona 
fide services provided during the immediately preceding 36-month period 
or full period of services provided to the employer if the employee has 
been providing services to the service recipient for a period of less 
than 36 months (or that the level of bona fide services would not be so 
reduced). For example, an employee may demonstrate that the employer 
and employee reasonably anticipated that the employee would cease 
providing services, but that, after the original cessation of services, 
business circumstances such as termination of the employee's 
replacement caused the employee to return to employment. Although the 
employee's return to employment may cause the employee to be presumed 
to have continued in employment because the employee is providing 
services at a rate equal to the rate at which the employee was 
providing services before the termination of employment, the facts and 
circumstances in this case would demonstrate that at the time the 
employee originally ceased to provide services, the employee and the 
service recipient reasonably anticipated that the employee would not 
provide services in

[[Page 19296]]

the future. Notwithstanding the foregoing provisions of this paragraph 
(h)(1)(ii), a plan may treat another level of reasonably anticipated 
permanent reduction in the level of bona fide services as a separation 
from service, provided that the level of reduction required must be 
designated in writing as a specific percentage, and the reasonably 
anticipated reduced level of bona fide services must be greater than 20 
percent but less than 50 percent of the average level of bona fide 
services provided in the immediately preceding 12 months. The plan must 
specify the definition of separation from service on or before the date 
on which a separation from service is designated as a time of payment 
of the applicable amount deferred, and once designated, any change to 
the definition of separation from service with respect to such amount 
deferred will be subject to the rules regarding subsequent deferrals 
and the acceleration of payments. For purposes of this paragraph 
(h)(1)(ii), for periods during which an employee is on a paid bona fide 
leave of absence (as defined in paragraph (h)(1)(i) of this section) 
and has not otherwise terminated employment pursuant to paragraph 
(h)(1)(i) of this section, the employee is treated as providing bona 
fide services at a level equal to the level of services that the 
employee would have been required to perform to receive the 
compensation paid with respect to such leave of absence. Periods during 
which an employee is on an unpaid bona fide leave of absence (as 
defined in paragraph (h)(1)(i) of this section) and has not otherwise 
terminated employment pursuant to paragraph (h)(1)(i) of this section, 
are disregarded for purposes of this paragraph (h)(1)(ii) (including 
for purposes of determining the applicable 36-month (or shorter) 
period).
    (2) Independent contractors--(i) In general. An independent 
contractor is considered to have a separation from 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 (h)(2)(i) of this 
section, a plan is considered to satisfy the requirement described in 
Sec.  1.409A-3(a)(1) with respect to an amount payable upon a 
separation from service if, with respect to amounts payable to a 
service provider who is an independent contractor, the plan provides 
that--
    (A) No amount will be paid to the service provider before a date at 
least 12 months after the day on which the contract expires under which 
the service provider performs services for the service recipient (or, 
in the case of more than one contract, all such contracts expire); and
    (B) No amount payable to the service provider on that date will be 
paid to the service provider if, after the expiration of the contract 
(or contracts) and before that date, the service provider performs 
services for the service recipient as an independent contractor or an 
employee.
    (3) Definition of service recipient and employer. For purposes of 
this paragraph (h), the term service recipient or employer means the 
service recipient as defined in paragraph (g) of this section, provided 
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), ``at least 50 percent'' is used instead 
of ``at least 80 percent'' each place it appears in Sec.  1.414(c)-2. A 
plan may provide with respect to a deferral of compensation under the 
plan that in applying sections 1563(a)(1), (2), and (3) for purposes of 
determining a controlled group of corporations under section 414(b), 
another defined percentage greater than 50 percent, but not greater 
than 80 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), another defined percentage greater than 50 
percent, but not greater than 80 percent, is used instead of ``at least 
80 percent'' at each place it appears in Sec.  1.414(c)-2. In addition, 
where the use of such definition of service recipient for purposes of 
determining a separation from service is based upon legitimate business 
criteria, the plan may provide that for purposes of a deferral of 
compensation under the plan 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'' or another 
defined percentage not less than 20 percent but not greater than 50 
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'' or another defined 
percentage not less than 20 percent but not greater than 50 percent is 
used instead of ``at least 80 percent'' at each place it appears in 
Sec.  1.414(c)-2. Where a definition of service recipient or employer 
other than the definition provided in the first sentence of this 
paragraph (h)(3) (the 50 percent standard) is used, the plan must 
designate in writing the alternate definition no later than the last 
date at which the time and form of payment of the applicable amount 
deferred must be elected in accordance with Sec.  1.409A-2(a), and any 
change in the definition for such amounts deferred will constitute a 
change in the time and form of payment subject to the rules governing 
subsequent deferral elections under Sec.  1.409A-2(b) and the 
acceleration of payments under Sec.  1.409A-3(j).
    (4) Asset purchase transactions. Where as part of a sale or other 
disposition of assets by one service recipient (seller) to an unrelated 
service recipient (buyer), a service provider of the seller would 
otherwise experience a separation from service with the seller, the 
seller and the buyer may retain the discretion to specify, and may 
specify, whether a service provider providing services to the seller 
immediately before the asset purchase transaction and providing 
services to the buyer after and in connection with the asset purchase 
transaction has experienced a separation from service for purposes of 
this

[[Page 19297]]

paragraph (h), provided that the asset purchase transaction results 
from bona fide, arm's length negotiations, all service providers 
providing services to the seller immediately before the asset purchase 
transaction and providing services to the buyer after and in connection 
with the asset purchase transaction are treated consistently 
(regardless of position at the seller) for purposes of applying the 
provisions of any nonqualified deferred compensation plan, and such 
treatment is specified in writing no later than the closing date of the 
asset purchase transaction. For purposes of this paragraph (h)(4), 
references to a sale or other disposition of assets, or an asset 
purchase transaction, refer only to a transfer of substantial assets, 
such as a plant or division or substantially all the assets of a trade 
or business. For purposes of this paragraph (h)(4), whether a service 
recipient is related to another service recipient is determined under 
the rules provided in paragraph (f)(2)(ii) of this section.
    (5) Dual status. If a service provider provides services both as an 
employee of a service recipient and as an independent contractor of a 
service recipient, the service provider must separate from service both 
as an employee and as an independent contractor to be treated as having 
separated from service. If a service provider ceases providing services 
as an independent contractor and begins providing services as an 
employee, or ceases providing services as an employee and begins 
providing services as an independent contractor, the service provider 
will not be considered to have a separation from service until the 
service provider has ceased providing services in both capacities. 
Notwithstanding the foregoing, if a service provider provides services 
both as an employee of a service recipient and a member of the board of 
directors of a corporate service recipient (or an analogous position 
with respect to a non-corporate service recipient), the services 
provided as a director are not taken into account in determining 
whether the service provider has a separation from service as an 
employee for purposes of a nonqualified deferred compensation plan in 
which the service provider participates as an employee that is not 
aggregated with any plan in which the service provider participates as 
a director under paragraph (c)(2)(ii) of this section. In addition, if 
a service provider provides services both as an employee of a service 
recipient and a member of the board of directors of a corporate service 
recipient (or an analogous position with respect to a non-corporate 
service recipient), the services provided as an employee are not taken 
into account in determining whether the service provider has a 
separation from service as a director for purposes of a nonqualified 
deferred compensation plan in which the service provider participates 
as a director that is not aggregated with any plan in which the service 
provider participates as an employee under paragraph (c)(2)(ii) of this 
section.
    (6) Collectively bargained plans covering multiple employers. 
Notwithstanding the foregoing provisions of this paragraph (h), to the 
extent a plan is established pursuant to a bona fide collective 
bargaining agreement covering services performed by employees for 
multiple employers, such plan may define a separation from service in a 
reasonable manner that treats the employee as not having separated from 
service during periods in which the employee is not providing services 
but is available to perform services covered by the collective 
bargaining agreement for one or more employers, provided that the 
definition also provides that the employee must be deemed to have 
separated from service at a specified date not later than the end of 
any period of at least 12 consecutive months during which the employee 
has not provided any services covered by the collective bargaining 
agreement to any participating employer. This paragraph (h)(6) applies 
only if the definition of separation from service provided by the 
collective bargaining agreement was the subject of arm's length 
negotiations between employee representatives and two or more 
employers, the agreement between employee representatives and such 
employers satisfies section 7701(a)(46), and the circumstances 
surrounding the agreement evidence good faith bargaining between 
adverse parties over such definition.
    (i) Specified employee--(1) In general. The term specified employee 
means a service provider who, as of the date of the service provider's 
separation from service, is a key employee 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), a service provider 
is a key employee if the service provider 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 a specified employee 
identification date. If a service provider is a key employee as of a 
specified employee identification date, the service provider is treated 
as a key employee for purposes of this paragraph (i) for the entire 12-
month period beginning on the specified employee effective date.
    (2) Definition of compensation. For purposes of identifying a 
specified employee by applying the requirements of section 
416(i)(1)(A)(i), (ii), and (iii), the definition of compensation under 
Sec.  1.415(c)-2(a) is used, applied as if the service recipient were 
not using any safe harbor provided in Sec.  1.415(c)-2(d), were not 
using any of the special timing rules provided in Sec.  1.415(c)-2(e), 
and were not using any of the special rules provided in Sec.  1.415(c)-
2(g). Notwithstanding the foregoing, a service recipient may elect to 
use any available definition of compensation under section 415 and the 
regulations thereunder in accordance with the election requirements set 
forth in paragraph (i)(8) of this section, including any available safe 
harbor and any available election under the timing rules or special 
rules, provided that the definition is applied consistently to all 
employees of the service recipient for purposes of identifying 
specified employees. A service recipient may elect to use such an 
alternative definition regardless of whether another definition of 
compensation is being used for purposes of a qualified plan sponsored 
by the service recipient. However, once a list of specified employees 
has become effective, the service recipient cannot change the 
definition of compensation for purposes of identifying specified 
employees for the period with respect to which such list is effective.
    (3) Specified employee identification date. Unless another date is 
designated in accordance with the requirements of this paragraph (i)(3) 
and paragraph (i)(8) of this section, the specified employee 
identification date is December 31. A service recipient may designate 
in accordance with the requirements of paragraph (i)(8) of this section 
any other date as the specified employee identification date, provided 
that a service recipient must use the same specified employee 
identification date with respect to all nonqualified deferred 
compensation plans, and any change to the specified employee 
identification date may not be effective for a period of at least 12 
months. The service recipient may designate a specified employee 
identification date in each plan or in a separate document applicable 
to all plans, provided that the service recipient will not be treated 
as having designated a specified employee identification date before 
the

[[Page 19298]]

designation is legally binding on the service recipient and all 
affected service providers. Any designation of a specified employee 
identification date made on or before December 31, 2007, may be applied 
to any separation from service occurring on or after January 1, 2005, 
unless and until subsequently changed pursuant to this paragraph 
(i)(3).
    (4) Specified employee effective date. Unless another date is 
designated in accordance with the requirements of this paragraph (i)(4) 
and paragraph (i)(8) of this section, the specified employee effective 
date is the first day of the fourth month following the specified 
employee identification date. A service recipient may designate in 
accordance with the requirements of paragraph (i)(8) of this section 
any date following the specified employee identification date as the 
specified employee effective date, provided that such date may not be 
later than the first day of the fourth month following the specified 
employee identification date, and provided further that a service 
recipient must use the same specified employee effective date with 
respect to all nonqualified deferred compensation plans, and any change 
to the specified employee effective date may not be effective for a 
period of at least 12 months. The service recipient may designate a 
specified employee effective date through inclusion in each plan 
document or through a separate document applicable to all plans, 
provided that the service recipient will not be treated as having 
designated a specified employee effective date on any date before the 
designation is legally binding on the service recipient and all 
affected service providers. Any designation of a specified employee 
effective date made on or before December 31, 2007, may be applied to 
any separation from service occurring on or after January 1, 2005, 
unless and until subsequently changed pursuant to this paragraph 
(i)(4).
    (5) Alternative methods of satisfying the six-month delay rule. A 
plan may provide, in accordance with the requirements of paragraph 
(i)(8) of this section, for an alternative method to identify service 
providers who will be subject to the six-month delay rule provided in 
section 409A(a)(2)(B)(i), provided that the alternative method is 
reasonably designed to include all specified employees (determined 
without respect to any available service recipient elections), the 
alternative method is an objectively determinable standard providing no 
direct or indirect election to any service provider regarding its 
application, and the alternative method results in either all service 
providers or no more than 200 service providers being identified in the 
class as of any date. Use of such an alternative method will not be 
treated as a change in the time and form of payment for purposes of 
Sec.  1.409A-2(b) (the subsequent deferral rules), even if the service 
provider is not a specified employee when the payment is delayed.
    (6) Corporate transactions--(i) Mergers and acquisitions of public 
service recipients. If as a result of a corporate transaction, two or 
more separate service recipients, more than one of which has stock 
outstanding that is publicly traded on an established securities market 
or otherwise immediately before the transaction, become one service 
recipient, any stock of which is publicly traded on an established 
securities market or otherwise immediately after the transaction 
(resulting public service recipient), the resulting public service 
recipient's next specified employee identification date and specified 
employee effective date following the corporate transaction are the 
specified employee identification date and specified employee effective 
date that the acquiring service recipient would have been required to 
use absent such transaction. For this purpose, in the case of a 
corporate merger, the acquiring service recipient is the service 
recipient that included the surviving corporation in such merger, in 
the case of an acquisition by a corporation of the stock of another 
corporation, the acquiring service recipient is the service recipient 
that included the corporation that acquired such stock, and in all 
other cases, the surviving service recipient is determined on the basis 
of all of the facts and circumstances. For the period between the 
transaction and the next specified employee effective date, the list of 
specified employees of the resulting public service recipient is 
determined by combining the lists of specified employees of all service 
recipients participating in the transaction that were in effect at the 
date of the corporate transaction, ranking such specified employees in 
order of the amount of compensation used to determine each specified 
employee's status as a specified employee, and treating the top 50 of 
such specified employees, plus any employees described in section 
416(i)(1)(ii) or section 416(i)(1)(iii) and the regulations thereunder 
(relating to 1-percent and 5-percent owners) who are not included in 
such top 50 specified employees, as specified employees for the period 
between the corporate transaction and the next specified employee 
effective date. Alternatively, the resulting service recipient may 
elect in accordance with the requirements of paragraph (i)(8) of this 
section to use any reasonable method to determine the specified 
employees of the resulting service recipient, including the use of an 
alternative method of compliance described in paragraph (i)(5) of this 
section, provided that such method is adopted no later than 90 days 
after the corporate transaction and applied prospectively from the date 
the method is adopted.
    (ii) Mergers and acquisitions of nonpublic service recipients. If 
as part of a corporate transaction a service recipient that does not 
have outstanding stock that is publicly traded on an established 
securities market or otherwise immediately before the transaction 
(initial private service recipient), and a service recipient with stock 
outstanding that is publicly traded on an established securities market 
or otherwise immediately before the transaction (initial public service 
recipient), become a single service recipient having stock that is 
publicly traded on an established securities market or otherwise 
immediately after the transaction (resulting public service recipient), 
the resulting public service recipient's next specified employee 
identification date and specified employee effective date following the 
corporate transaction are the specified employee identification date 
and specified employee effective date that the initial public service 
recipient would have been required to use absent such transaction. For 
the period after the date of the corporate transaction and before the 
next specified employee effective date, the specified employees of the 
initial public service recipient immediately before the transaction 
continue to be the specified employees of the resulting public service 
recipient, and no service providers of the initial private service 
recipient are required to be treated as specified employees.
    (iii) Spinoffs. If as part of a corporate transaction, a service 
recipient with stock outstanding that is publicly traded on an 
established securities market or otherwise immediately before the 
transaction (initial public service recipient), becomes two or more 
separate service recipients, each with stock outstanding that is 
publicly traded on an established securities market or otherwise 
immediately after the transaction (post-transaction public service 
recipients), the next specified employee identification date of each of 
the post-transaction public service recipients is the specified 
employee identification date that the initial public

[[Page 19299]]

service recipient would have been required to use absent such 
transaction. For the period after the date of the corporate transaction 
and before the next specified employee effective date, the specified 
employees of the initial public service recipient immediately before 
the transaction continue to be the specified employees of the post-
transaction public service recipients.
    (iv) Public offerings and other corporate transactions. If as part 
of an initial public offering or corporate transaction not described in 
paragraph (i)(6)(ii) or (iii) of this section, a service recipient with 
no outstanding stock that is publicly traded on an established 
securities market or otherwise immediately before such offering or 
other transaction (initial private service recipient), becomes one or 
more service recipients with stock outstanding that is publicly traded 
on an established securities market or otherwise immediately after such 
offering or other transaction (post-transaction public service 
recipient), each post-transaction public service recipient has a 
specified employee identification date of December 31 and a specified 
employee effective date of April 1, effective retroactively to the 
December 31 and April 1 next preceding the offering or other 
transaction for purposes of identifying the specified employees between 
the corporation transaction and the next December 31. Alternatively, a 
post-transaction public service recipient may elect in accordance with 
the requirements of paragraph (i)(8) of this section, a specified 
employee identification date and specified employee effective date on 
or before the date of the offering or other transaction. If a public 
service recipient makes such an election, for the period after the 
offering or other transaction and before the next specified employee 
effective date, the specified employees of the post-transaction public 
service recipient consist of the service providers that at the time of 
the offering or other transaction would have been classified as 
specified employees of the initial private service recipient, had the 
initial private service recipient elected the same specified employee 
identification date and specified employee effective date as selected 
by the post-transaction public service recipient, and had such initial 
private service recipient had stock publicly traded on an established 
securities market or otherwise as of the specified employee 
identification date preceding the transaction.
    (v) Alternative methods of compliance. For purposes of this 
paragraph (i)(6), references to specified employees as of a corporate 
transaction or offering include any specified employees identified 
through the use of an alternative method described in paragraph (i)(5) 
of this section, where the use of such alternative method was 
established and effective at the time of the corporate transaction or 
offering.
    (7) Nonresident alien employees. For purposes of determining 
whether an 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)), and therefore is a key employee, 
the incorporation of the rules of Sec.  1.415(c)-2(g)(5) regarding the 
definition of compensation applies. Accordingly, the rule of Sec.  
1.415(c)-2(g)(5)(i), generally requiring the treatment as compensation 
of certain compensation excludible from an employee's gross income due 
to the location of the services or the identity of the employer, 
applies. In addition, a service recipient may elect in accordance with 
paragraph (i)(8) of this section to apply the rule of Sec.  1.415(c)-
2(g)(5)(ii) to not treat as compensation certain compensation 
excludible from an employee's gross income on account of the location 
of the services or the identity of the employer that is not effectively 
connected with the conduct of a trade or business within the United 
States. A service recipient may elect to apply the rule of Sec.  1.415-
2(g)(5)(ii) regardless of whether the service recipient has elected to 
apply the rule to a qualified plan sponsored by the service recipient; 
however, once a list of specified employees has become effective, any 
election of the rule for that period may not be changed. 
Notwithstanding the foregoing, any election of the rule made before 
January 1, 2008, may be effective with respect to any specified 
employee identification date on or before December 31, 2007.
    (8) Elections affecting the identification of specified employees. 
The elections described in paragraphs (i)(2) through (7) of this 
section are effective only as of the date that all necessary corporate 
action has been taken to make such elections binding for purposes of 
all affected nonqualified deferred compensation plans in which the 
service providers of the service recipient that would become a 
specified employee due to the application of such election participate. 
Where a taxpayer attempts to make an election under paragraph (i)(2), 
(3), (4), (5), (6), or (7) of this section but such election is not 
binding on all the affected nonqualified deferred compensation plans 
and applied consistently to all such service providers, the election is 
not effective and the rule under paragraph (i)(2), (3), (4), (5), (6), 
or (7) of this section, as applicable, that would apply absent an 
election is applicable for identifying specified employees.
    (j) Nonresident alien. (1) Except as provided in paragraph (j)(2) 
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. The term established securities 
market means an established securities market within the meaning of 
Sec.  1.897-1(m).
    (l) Stock right. 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 plan described in 
section 423) or a stock appreciation right.
    (m) Separation pay plan. The term separation pay plan means any 
plan that provides separation pay or, where a plan provides both 
amounts that are separation pay and that are not separation pay, that 
portion of the plan that provides separation pay. The term separation 
pay means any deferral of compensation (before the application of the 
exclusions from the definition of a deferral of compensation set forth 
in paragraph (b)(9) of this section) that will not be paid under any 
circumstances unless the service provider has had a separation from 
service, whether voluntary or involuntary, including payments in the 
form of reimbursements of expenses incurred, and the provision of in-
kind benefits. A deferral of compensation that the service provider may 
receive without a separation from service does not become separation 
pay merely because the service provider elects to receive or receives 
the payment after or upon a separation from service.

[[Page 19300]]

A deferral of compensation does not fail to be separation pay merely 
because the payment is conditioned upon the execution of a release of 
claims, noncompetition or nondisclosure provisions, or other similar 
requirements. 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 nonqualified deferred 
compensation plan constitutes a payment of compensation or deferral of 
compensation under such nonqualified deferred compensation plan.
    (n) Involuntary separation from service--(1) In general. An 
involuntary separation from service means a separation from service due 
to the independent exercise of the unilateral authority of the service 
recipient to terminate the service provider's services, other than due 
to the service provider's implicit or explicit request, where the 
service provider was willing and able to continue performing services. 
An involuntary separation from service may include the service 
recipient's failure to renew a contract at the time such contract 
expires, provided that the service provider was willing and able to 
execute a new contract providing terms and conditions substantially 
similar to those in the expiring contract and to continue providing 
such services. The determination of whether a separation from service 
is involuntary is based on all the facts and circumstances. Any 
characterization of the separation from service as voluntary or 
involuntary by the service provider and the service recipient in the 
documentation of the separation from service is presumed to properly 
characterize the nature of the separation from service. However, the 
presumption may be rebutted where the facts and circumstances indicate 
otherwise. For example, if a separation from service is designated as a 
voluntary separation from service or resignation, but the facts and 
circumstances indicate that absent such voluntary separation from 
service the service recipient would have terminated the service 
provider's services, and that the service provider had knowledge that 
the service provider would be so terminated, the separation from 
service is involuntary.
    (2) Separations from service for good reason--(i) In general. 
Notwithstanding paragraph (n)(1) of this section, a service provider's 
voluntary separation from service will be treated for purposes of this 
section and Sec. Sec.  1.409A-2 through 1.409A-6 as an involuntary 
separation from service if the separation from service occurs under 
certain limited bona fide conditions, where the avoidance of the 
requirements of section 409A is not a purpose of the inclusion of these 
conditions in the plan or of the actions by the service recipient in 
connection with the satisfaction of these conditions, and a voluntary 
separation from service under such conditions effectively constitutes 
an involuntary separation from service. Generally such conditions will 
be prespecified under an agreement to provide compensation upon a 
separation from service for good reason. Such a good reason (or a 
similar condition) must be defined to require actions taken by the 
service recipient resulting in a material negative change to the 
service provider in the service relationship, such as the duties to be 
performed, the conditions under which such duties are to be performed, 
or the compensation to be received for performing such services. Other 
factors taken into account in determining whether a separation from 
service for good reason effectively constitutes an involuntary 
separation from service include the extent to which the payments upon a 
separation from service for good reason are in the same amount and are 
to be made at the same time and in the same form as payments available 
upon an actual involuntary separation from service, and whether the 
service provider is required to give the service recipient notice of 
the existence of the condition that would result in treatment as a 
separation from service for good reason and a reasonable opportunity to 
remedy the condition.
    (ii) Safe harbor. For purposes of this section and Sec. Sec.  
1.409A-2 through 1.409A-6, if a plan provides that a voluntary 
separation from service will be treated as an involuntary separation 
from service if the separation from service occurs under certain 
express conditions, a separation from service satisfying the conditions 
set forth in the plan will be treated as an involuntary separation from 
the service if the necessary conditions (or set of conditions) require 
the following:
    (A) The separation from service must occur during a pre-determined 
limited period of time not to exceed two years following the initial 
existence of one or more of the following conditions arising without 
the consent of the service provider:
    (1) A material diminution in the service provider's base 
compensation.
    (2) A material diminution in the service provider's authority, 
duties, or responsibilities.
    (3) A material diminution in the authority, duties, or 
responsibilities of the supervisor to whom the service provider is 
required to report, including a requirement that a service provider 
report to a corporate officer or employee instead of reporting directly 
to the board of directors of a corporation (or similar governing body 
with respect to an entity other than a corporation).
    (4) A material diminution in the budget over which the service 
provider retains authority.
    (5) A material change in the geographic location at which the 
service provider must perform the services.
    (6) Any other action or inaction that constitutes a material breach 
by the service recipient of the agreement under which the service 
provider provides services.
    (B) The amount, time, and form of payment upon the separation from 
service must be substantially identical to the amount, time and form of 
payment payable due to an actual involuntary separation from service, 
to the extent such a right exists.
    (C) The service provider must be required to provide notice to the 
service recipient of the existence of the condition described in 
paragraph (n)(2)(ii)(A) of this section within a period not to exceed 
90 days of the initial existence of the condition, upon the notice of 
which the service recipient must be provided a period of at least 30 
days during which it may remedy the condition and not be required to 
pay the amount.
    (3) Special rule for certain collectively bargained plans. 
Notwithstanding the foregoing, for purposes of this paragraph (n), to 
the extent a plan is subject to a bona fide collective bargaining 
agreement covering services performed for multiple employers under 
which an employee must separate from service with all such employers in 
order to receive a payment, such plan may use any reasonable definition 
of involuntary separation from service, provided that such definition 
is consistent with any definition of a separation from service adopted 
under paragraph (h)(6) of this section, and provided further that the 
definition of an involuntary separation from service provided by the 
collective bargaining agreement was the subject of arm's length 
negotiations between employee representatives and two or more 
employers, the agreement between employee representatives and such 
employers satisfies section 7701(a)(46), and the circumstances 
surrounding the agreement evidence good faith bargaining between 
adverse parties over such definition.
    (o) Earnings. Whether a deferred amount constitutes earnings on an 
amount deferred, or actual or notional income attributable to an amount 
deferred, is determined under the

[[Page 19301]]

principles defining income attributable to the amount taken into 
account under Sec.  31.3121(v)(2)-1(d)(2) of this chapter. Accordingly, 
with respect to an account balance plan, earnings on an amount deferred 
generally include an amount credited on behalf of a service provider 
under the terms of the plan that reflects a rate of return that does 
not exceed either the rate of return on a predetermined actual 
investment or, if the income does not reflect the rate of return on a 
predetermined actual investment, a reasonable rate of interest. With 
respect to nonaccount balance plans, earnings on an amount deferred 
generally include an 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 amount deferred (determined as of the date such amount 
was deferred), but only if the amount deferred was determined using 
reasonable actuarial assumptions and methods. A right to earnings on an 
amount deferred generally is treated as a right to a deferral of 
compensation for purposes of this section and Sec. Sec.  1.409A-2 
through 1.409A-6. However, for purposes of any provision of this 
section and Sec. Sec.  1.409A-2 through 1.409A-6 referring to earnings 
on deferred compensation (or similar terms), the use of an unreasonable 
rate of return, or unreasonable actuarial assumptions and methods, 
generally will result in the treatment of some or all of such a right 
to deferred compensation as a right only to deferred compensation, and 
not a right to earnings on deferred compensation, so that the provision 
will not be applicable. With respect to plans that are neither account 
balance plans nor nonaccount balance plans, these rules apply by 
analogy.
    (p) In-kind benefits. The term in-kind benefits refers to services 
provided to or on behalf of a service provider, such as financial 
planning services, or tangible personal or real property made available 
for use by or on behalf of the service provider, such as the use of an 
aircraft or vehicle, and does not refer to a transfer of property 
within the meaning of section 83 and the regulations thereunder, or a 
promise to transfer, or an option to purchase or receive, property in 
the future.
    (q) Application of definitions and rules. The definitions and rules 
set forth in paragraphs (a) through (p) of this section apply for 
purposes of section 409A, this section, and Sec. Sec.  1.409A-2 through 
1.409A-6.


Sec.  1.409A-2  Deferral elections.

    (a) Initial elections as to the time and form of payment--(1) In 
general. A plan that is, or constitutes part of, a nonqualified 
deferred compensation plan meets the requirements of section 
409A(a)(4)(B) only if under the terms of the plan, 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 latest date permitted in this paragraph 
(a). An election will not be considered to be revocable merely because 
the service provider or service recipient may make an election to 
change the time and form of payment pursuant to paragraph (b) of this 
section, or the service recipient may accelerate the time of payment 
pursuant to Sec.  1.409A-3(j)(4) (exceptions to prohibition on 
accelerated payments). Whether a plan 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 expressly provided in this section, an election will not 
be considered made until such election becomes irrevocable under the 
terms of the applicable plan. Accordingly, a plan may provide that an 
election to defer may be changed at any time before the last 
permissible date for making such an election. Where a plan 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 a plan 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 in connection with 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. 
For purposes of this paragraph (a), the reference to a service period 
or a performance period refers to the period of service for which the 
right to the compensation arises, and may include periods before the 
grant of a legally binding right to the compensation. For example, 
where a service recipient grants a bonus based upon services performed 
in the calendar year 2010, but retains the discretion to rescind the 
bonus until 2011 such that the promise of the bonus is not a legally 
binding right, the period of service or performance period to which the 
compensation relates is the calendar year 2010.
    (2) Service recipient elections. A plan 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 or form of payment of such 
compensation must designate the time and form of payment by no later 
than the later of the time the service provider first has a legally 
binding right to the compensation or, if later, the time the service 
provider would be required under this section to make such an election 
if the service provider were provided such an election. Such 
designation is treated as an initial deferral election for purposes of 
this section. Where a plan permits a service recipient to exercise 
discretion to disregard a service provider election as to the time or 
form of a payment, any service provider election that is subject to 
such discretion will be treated as revocable so long as such discretion 
may be exercised.
    (3) General rule. A plan that is, or constitutes part of, a 
nonqualified deferred compensation plan meets the requirements of 
section 409A(a)(4)(B) if under the terms of the plan, 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.
    (4) Initial deferral election with respect to short-term deferrals. 
If a service provider has a legally binding right to a payment of 
compensation in a subsequent taxable year that, absent a deferral 
election, would be treated as a short-term deferral within the meaning

[[Page 19302]]

of 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(i)(5)) without regard to the five-
year additional deferral requirement in paragraph (b) of this section.
    (5) Initial deferral election with respect to certain forfeitable 
rights. If a service provider has a legally binding right to a payment 
in a subsequent year that is subject to a condition requiring the 
service provider to continue to provide services for a period of at 
least 12 months from the date the service provider obtains the legally 
binding right to avoid forfeiture of the payment, 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. For 
purposes of this paragraph (a)(5), a condition will not be treated as 
failing to require the service provider to continue to provide services 
for a period of at least 12 months from the date the service provider 
obtains the legally binding right merely because the condition 
immediately lapses upon the death or disability (as defined in Sec.  
1.409A-3(i)(4)) of the service provider, or upon a change in control 
event (as defined in Sec.  1.409A-3(i)(5)), provided that if death, 
disability, or a change in control event occurs and the condition 
lapses before the end of such 12-month period, a deferral election may 
be given effect only if the deferral election is permitted under this 
section without regard to this paragraph (a)(5).
    (6) Initial deferral election with respect to fiscal year 
compensation. In the case of a service recipient with a taxable year 
that is not the same as the taxable year of the service provider, 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 taxable year immediately preceding the first taxable year 
of the service recipient in which any services are performed for which 
such compensation is payable. For purposes of this paragraph (a)(6), 
the term fiscal year compensation means compensation relating to a 
period of service coextensive with one or more consecutive taxable 
years of the service recipient, of which no amount is paid or payable 
during the service recipient's taxable year or years constituting the 
period of service. For example, fiscal year compensation generally 
would include a bonus to an individual employee with a calendar year 
taxable year that is based on a service period consisting of the 
service recipient's two consecutive taxable years ending September 30, 
2011, where the amount will be paid after the end of the second of such 
taxable years, but would not include either a bonus based on a service 
period consisting of one or more calendar years or salary that would 
otherwise be paid during such taxable years of the service recipient.
    (7) First year of eligibility--(i) In general. In the case of the 
first year in which a service provider becomes eligible to participate 
in a plan, 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 after the election. In the case of a plan that 
does not provide for service provider 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 first 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 
performance period, the election must apply only to the compensation 
paid for services performed after the election. For this purpose, an 
election will be deemed to apply to compensation paid for services 
performed after the election if the election applies to no more than an 
amount equal to the total amount of the 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.
    (ii) Eligibility to participate. For purposes of this paragraph 
(a)(7), a service provider is eligible to participate in a plan at any 
time during which, under the plan's terms and without further amendment 
or action by the service recipient, the service provider is eligible to 
accrue an amount of deferred compensation under the plan other than 
earnings on amounts previously deferred, even if the service provider 
has elected not to accrue (or has not elected to accrue) an amount of 
deferred compensation. Where a service provider has been paid all 
amounts deferred under a plan, and on and before the date of the last 
payment was not eligible to continue (or to elect to continue) to 
participate in the plan for periods after the last payment (other than 
through an election of a different time and form of payment with 
respect to the amounts paid), the service provider may be treated as 
initially eligible to participate in a plan as of the first date 
following such payment that the service provider becomes eligible to 
accrue an additional amount of deferred compensation. Where a service 
provider has ceased being eligible to participate in a plan (other than 
the accrual of earnings), regardless of whether all amounts deferred 
under the plan have been paid, and subsequently becomes eligible to 
participate in the plan again, the service provider may be treated as 
being initially eligible to participate in the plan if the service 
provider had not been eligible to participate in the plan (other than 
the accrual of earnings) at any time during the 24-month period ending 
on the date the service provider again becomes eligible to participate 
in the plan.
    (iii) Application to excess benefit plans. For purposes of this 
paragraph (a)(7), a service provider is treated as initially eligible 
to participate in an excess benefit plan as of the first day of the 
service provider's taxable year immediately following the first year 
the service provider accrues a benefit under the excess benefit plan; 
and any election made within 30 days following such date is treated as 
applying to benefits accrued under such plan for services performed 
before the election. For purposes of this paragraph (a)(7), the term 
excess benefit plan means all nonqualified deferred compensation plans 
in which a service provider participates, to the extent such plans do 
not provide for an election between current compensation (including a 
short-term deferral) and deferred compensation and solely provide 
deferred compensation equal to the excess of the benefits the service 
provider would have accrued under a qualified employer plan (as defined 
in Sec.  1.409A-1(a)(2)) in which the service provider also 
participates, in the absence of one or more of the limits incorporated 
into the plan to reflect one or more of the limits on contributions or 
benefits applicable to the qualified

[[Page 19303]]

employer plan under the Internal Revenue Code, over the benefits the 
service provider actually accrues under the qualified employer plan. 
For purposes of this paragraph (a)(7), once a service provider has 
accrued a benefit or deferred compensation under a plan in any year, 
the service provider will not become eligible for an initial deferral 
election based upon an accrual or deferral under an excess benefit plan 
in a subsequent year, even if the benefit or deferred compensation 
accrued in a previous year is forfeited or eliminated.
    (8) Initial deferral election with respect to performance-based 
compensation. In the case of any performance-based compensation (as 
defined in Sec.  1.409A-1(e)), an initial deferral election may be made 
with respect to such performance-based compensation on or before the 
date that is six months before the end of the performance period, 
provided that the service provider performs services continuously from 
the later of the beginning of the performance period or the date the 
performance criteria are established through the date an election is 
made under this paragraph (a)(8), and provided further that in no event 
may an election to defer performance-based compensation be made after 
such compensation has become readily ascertainable. For purposes of 
this paragraph (a)(8), if the performance-based compensation is a 
specified or calculable amount, the compensation is readily 
ascertainable if and when the amount is first substantially certain to 
be paid. If the performance-based compensation is not a specified or 
calculable amount because, for example, the amount may vary based upon 
the level of performance, the compensation, or any portion of the 
compensation, is readily ascertainable when the amount is first both 
calculable and substantially certain to be paid. For this purpose, the 
performance-based compensation is bifurcated between the portion that 
is readily ascertainable and the amount that is not readily 
ascertainable. Accordingly, in general any minimum amount that is both 
calculable and substantially certain to be paid will be treated as 
readily ascertainable.
    (9) Nonqualified deferred compensation plans linked to qualified 
employer plans or certain other arrangements. If a nonqualified 
deferred compensation plan provides that the amount deferred under the 
plan is determined under the formula for determining benefits under a 
qualified employer plan (as defined in Sec.  1.409A-1(a)(2)) or a 
broad-based foreign retirement plan (as defined in Sec.  1.409A-
1(a)(3)(v)) maintained by the service recipient but applied without 
regard to one or more limitations applicable to the qualified employer 
plan under the Internal Revenue Code or to the broad-based foreign 
retirement plan under other applicable law, or that the amount deferred 
under the nonqualified deferred compensation plan is determined as an 
amount offset by some or all of the benefits provided under the 
qualified employer plan or the broad-based foreign retirement plan, an 
increase in amounts deferred under the nonqualified deferred 
compensation plan that results directly from changes in benefit 
limitations applicable to the qualified employer plan or the broad-
based foreign retirement plan under the Internal Revenue Code or other 
applicable law does not constitute a deferral election under the 
nonqualified deferred compensation plan, 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, and provided further 
that such change in the amounts deferred under the nonqualified 
deferred compensation plan does not exceed that change in the amounts 
deferred under the qualified employer plan or the broad-based foreign 
retirement plan, as applicable. In addition, with respect to such a 
nonqualified deferred compensation plan, the following actions or 
failures to act will not constitute a deferral election under the 
nonqualified deferred compensation plan even if in accordance with the 
terms of the nonqualified deferred compensation plan, the actions or 
inactions result in an increase in the amounts deferred under the plan, 
provided that such actions or inactions do not otherwise affect the 
time or form of payment under the nonqualified deferred compensation 
plan and provided further that with respect to actions or inactions 
described in paragraphs (a)(9)(i) or (ii), the change in the amount 
deferred under the nonqualified deferred compensation plan does not 
exceed the change in the amounts deferred under the qualified employer 
plan or the broad-based foreign retirement plan, as applicable:
    (i) A service provider's action or inaction under the qualified 
employer plan or broad-based foreign retirement plan with respect to 
whether to elect to receive a subsidized benefit or an ancillary 
benefit under the qualified employer plan or broad-based foreign 
retirement plan.
    (ii) The amendment of a qualified employer plan or broad-based 
foreign retirement 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 or freeze or limit future accruals of benefits 
or reduce existing benefits under the broad-based foreign retirement 
plan.
    (iii) A service provider's action or inaction under a qualified 
employer plan with respect to elective deferrals and other employee 
pre-tax contributions subject to the contribution restrictions under 
section 401(a)(30) or section 402(g), including an adjustment to a 
deferral election under such qualified employer plan, provided that for 
any given taxable year, the service provider's action or inaction does 
not result in an increase in the amounts deferred under all 
nonqualified deferred compensation plans in which the service provider 
participates (other than amounts described in paragraph (a)(9)(iv) of 
this section) in excess of the limit with respect to elective deferrals 
under section 402(g)(1)(A), (B), and (C) 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 and other employee 
pre-tax contributions subject to the contribution restrictions under 
section 401(a)(30) or section 402(g), and after-tax contributions by 
the service provider to a qualified employer plan that provides for 
such contributions, that affects the amounts that are credited under 
one or more nonqualified deferred compensation plans as matching 
amounts or other similar amounts contingent on such elective deferrals, 
employee pre-tax contributions, or after-tax contributions, provided 
that the total of such matching or contingent amounts, as applicable, 
never exceeds 100 percent of the matching or contingent amounts that 
would be provided under the qualified employer plan absent any plan-
based restrictions that reflect limits on qualified plan contributions 
under the Internal Revenue Code.
    (10) Changes in elections under a cafeteria plan. A change in an 
election under a cafeteria plan does not constitute a deferral election 
with respect to an amount deferred under a nonqualified deferred 
compensation plan to the extent that the change in the amount deferred 
under the nonqualified deferred compensation plan results solely from 
the application of the change in amount eligible to be treated as 
compensation under the terms of the nonqualified deferred compensation 
plan resulting from the election change under the cafeteria plan, to a 
benefit formula under the nonqualified deferred compensation plan based 
upon the

[[Page 19304]]

service provider's eligible compensation, and only to the extent that 
such change applies in the same manner as any other increase or 
decrease in compensation would apply to such benefit formula.
    (11) Initial deferral election with respect to certain separation 
pay. In the case of separation pay (as defined in Sec.  1.409A-1(m)), 
where such separation pay is the subject of bona fide, arm's length 
negotiations at the time of the separation from service, an initial 
deferral election may be made at any time up to the time the service 
provider obtains a legally binding right to the payment. This paragraph 
(a)(11) does not apply to any separation pay to which the service 
provider obtained a legally binding right before the negotiations at 
the time of the separation from service, including a right to a payment 
subject to a condition such as that the service provider separate from 
service other than for cause. In the case of separation pay due to 
participation in a window program (as defined in Sec.  1.409A-
1(b)(9)(vi)), an initial deferral election may be made at any time 
before the time the election to participate in the window program 
becomes irrevocable.
    (12) Initial deferral election with respect to certain 
commissions--(i) Sales commission compensation. For purposes of this 
paragraph (a), a service provider earning sales commission compensation 
is treated as providing the services to which such compensation relates 
only in the service provider's taxable year in which the customer 
remits payment to the service recipient or, if applied consistently to 
all similarly situated service providers, the service provider's 
taxable year in which the sale occurs. For purposes of this paragraph 
(a)(12), the term sales 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 an 
unrelated 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 substantially all of which is 
calculated by reference to the volume of sales, and payment of the 
compensation is either contingent upon the service recipient receiving 
payment from an unrelated customer for the product or services or, if 
applied consistently to all similarly situated service providers, is 
contingent upon the closing of the sales transaction and such other 
requirements as may be specified by the service recipient before the 
closing of the sales transaction. 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)(2)(ii) or the 
person would be treated as providing management services to the other 
person under Sec.  1.409A-1(f)(2)(iv).
    (ii) Investment commission compensation. For purposes of this 
paragraph (a), a service provider earning investment commission 
compensation is treated as providing the services to which such 
compensation relates over the 12 months preceding the date as of which 
the overall value of the assets or asset accounts is determined for 
purposes of the calculation of the investment commission compensation. 
For purposes of this paragraph (a)(12), the term investment commission 
compensation means the compensation or the portion of compensation 
earned by a service provider if a substantial portion of the services 
provided by such service provider to a service recipient to which such 
compensation relates consists of sales of financial products or other 
direct customer services to an unrelated customer with respect to 
customer assets or customer asset accounts, the customer retains the 
right to terminate the customer relationship and may move or liquidate 
the assets or asset accounts without undue delay (which may be subject 
to a reasonable notice period), such compensation consists of a portion 
of the value of the overall assets or asset account balance, an amount 
substantially all of which is calculated by reference to the increase 
in the value of the overall assets or account balance during a 
specified period, or both, and the value of the overall assets or 
account balance and investment commission compensation is determined at 
least annually. 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)(2)(ii) or the person would be treated as 
providing management services to the other person under Sec.  1.409A-
1(f)(2)(iv).
    (iii) Commission compensation and related persons. The rules of 
paragraphs (a)(12)(i) and (ii) of this section apply to sales 
commission compensation and investment commission compensation 
involving a related customer, provided that substantial sales from 
which commission compensation arises are made, or substantial services 
from which commission compensation arises are provided, to unrelated 
customers by the service recipient, the sales and service arrangement 
and the commission arrangement with respect to the related customer are 
bona fide, arise from the service recipient's ordinary course of 
business, and are substantially the same, both in terms and in 
practice, as the terms and practices applicable to unrelated customers 
(as defined in such paragraphs) to which individually or in the 
aggregate substantial sales are made or substantial services provided 
by the service recipient.
    (13) Initial deferral election with respect to compensation paid 
for final payroll period--(i) In general. Unless a plan provides 
otherwise, compensation payable after the last day 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 in which the payment is made. 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 a plan 
after December 31, 2007, 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)(13), a 
plan that was adopted and effective before December 31, 2007, whether 
written or unwritten, will be treated as designating such compensation 
for services performed in the taxable year in which the payroll period 
ends, unless otherwise set forth in writing before December 31, 2007.
    (14) Elections to annualize recurring part-year compensation. In 
the case of a service provider receiving recurring part-year 
compensation, an election to defer all or a portion of the recurring

[[Page 19305]]

part-year compensation to be earned during a particular service period 
is considered to meet the requirements of this paragraph (a) if the 
election is made before the services for which the recurring part-year 
compensation is paid begin, and the election does not defer payment of 
any of the recurring part-year compensation to a date beyond the last 
day of the 13th month following the first date of the service period. 
For purposes of this paragraph (a)(14), the term recurring part-year 
compensation means compensation paid for services rendered in a 
position that the service recipient and service provider reasonably 
anticipate will continue on similar terms and conditions in subsequent 
years, and will require services to be provided during successive 
service periods each of which comprises less than 12 months (for 
example, a teacher providing services during a school year comprised of 
10 consecutive months), and each of which periods begins in one taxable 
year of the service provider and ends in the next such taxable year. 
The rules of this paragraph (a)(14) apply to a particular amount of 
compensation only once, so that an amount deferred under this rule may 
not again be treated as recurring part-year compensation for purposes 
of this paragraph and subject to a second deferral election under this 
paragraph (a)(14).
    (15) USERRA rights. The requirements of this paragraph (a) are 
deemed satisfied to the extent an initial deferral election is provided 
to satisfy the requirements of the Uniformed Service Employment and 
Reemployment Rights Act of 1994, as amended, 38 U.S.C. 4301-4334.
    (b) Subsequent changes in time and form of payment--(1) In general. 
A plan that permits under a subsequent election a delay in a payment or 
a change in the form of payment (a subsequent deferral election), 
including a subsequent deferral election made by a service provider or 
a service recipient, satisfies the requirements of section 
409A(a)(4)(C) only if the conditions of this paragraph (b) are met. For 
purposes of this paragraph (b), except as otherwise expressly provided 
in this section, a subsequent deferral election is not considered made 
until such election becomes irrevocable under the terms of the plan. 
Accordingly, a plan may provide that a subsequent deferral election may 
be changed at any time before the last permissible date for making such 
a subsequent deferral election. Where a plan permits a subsequent 
deferral election, the requirements of this paragraph are satisfied 
only if the following conditions are met:
    (i) The plan requires that such election 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 five 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, five 
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) be made not less than 12 months before 
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 
before 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 under a nondiscretionary formula. 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, a 
fringe benefit excludible under section 119 or section 132, or any 
other benefit that is excludible from gross income. For additional 
rules relating to the application of this paragraph (b) to amounts 
payable at a fixed time or pursuant to a fixed schedule, see Sec.  
1.409A-3(i)(1).
    (ii) Life annuities--(A) In general. The entitlement to a life 
annuity is treated as the entitlement to a single payment. Accordingly, 
an election to delay payment of a life annuity, or to change the form 
of payment of a life annuity, must be made at least 12 months before 
the scheduled commencement of the life annuity, and must defer the 
payment for a period of not less than five years from the originally 
scheduled commencement of the life annuity. For purposes of Sec.  
1.409A-1, this section, and Sec. Sec.  1.409A-3 through 1.409A-6, 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 a series of substantially 
equal periodic payments, payable not less frequently than annually, for 
the life (or life expectancy) of the service provider, followed upon 
the death or end of the life expectancy of the service provider by a 
series of substantially equal periodic payments, payable not less 
frequently then annually, for the life (or life expectancy) of the 
service provider's designated beneficiary (if any). A change in 
designated beneficiary before any annuity payment has been made under 
the plan is not a change in the time or form of payment. A change in 
the form of a payment before any annuity payment has been made under 
the plan, from one type of life annuity to another type of life annuity 
with the same scheduled date for the first annuity payment, is not 
considered a change in the time and form of a payment, provided that 
the annuities are actuarially equivalent applying reasonable actuarial 
methods and assumptions. For purposes of this paragraph (b)(2)(ii), a 
requirement that a service provider obtain the consent of a spouse or 
other potential recipient of a survivor annuity to change a beneficiary 
or form of payment is disregarded, so that any annuity form that the 
service recipient could elect to receive with such consent is 
considered currently available.
    (B) Certain features disregarded. Notwithstanding the foregoing 
provisions of this paragraph (b)(2)(ii), the following features are 
disregarded for purposes of determining whether a payment form is a 
life annuity within the meaning of this paragraph (b)(2)(ii), but are 
not disregarded for purposes of determining whether a life annuity is 
the actuarial equivalent of another life annuity except as otherwise 
provided in this paragraph (b)(2)(ii):
    (1) Term certain features under which annuity payments continue for 
the longer of the life of the annuitant or a fixed period of time.
    (2) Pop-up features under which payments increase upon the death of 
the

[[Page 19306]]

beneficiary or another event that eliminates the right to a survivor 
annuity.
    (3) Cash refund features under which payment is provided upon the 
death of the last annuitant in an amount that is not greater than the 
excess of the present value of the annuity at the annuity starting date 
over the total of payments before the death of the last annuitant.
    (4) Features under which an annuity form of payment provides higher 
periodic payments before the expected commencement of benefits under 
the Social Security Act (42 U.S.C. ch. 7) or the Railroad Retirement 
Act (45 U.S.C. 231 et seq.) and lower periodic payments after such 
expected commencement date, so that the combined periodic payments 
under the arrangement and the Social Security Act or the Railroad 
Retirement Act, as applicable, are approximately level before and after 
such expected commencement date (Social Security or Railroad Retirement 
leveling features).
    (5) Features providing for an increase in the annuity payment in a 
manner described in Sec.  1.401(a)(9)-6, Q&A-14(a)(1) or (2) (eligible 
cost-of-living adjustments).
    (C) Subsidized joint and survivor annuities. For purposes of this 
paragraph (b)(2)(ii), a joint and survivor annuity will not fail to be 
treated as actuarially equivalent to a single life annuity due solely 
to the value of a subsidized survivor annuity benefit, provided that 
the annual lifetime annuity benefit available to the service provider 
under the joint and survivor annuity is not greater than the annual 
lifetime annuity benefit available to the service provider under the 
single life annuity alternative, and provided that the annual survivor 
annuity benefit is not greater than the annual lifetime annuity benefit 
available to the service provider under the joint and survivor annuity.
    (D) Actuarial assumptions and methods. For purposes of this 
paragraph (b)(2)(ii), at any given time the same actuarial assumptions 
and methods must be used in valuing each annuity payment option, in 
determining whether the payments are actuarially equivalent and such 
assumptions must be reasonable. This requirement applies over the 
entire term of the service provider's participation in the plan, such 
that the annuity payment must be actuarially equivalent at all times 
for the annuity payment options to be treated as one time and form of 
payment. There is no requirement that the same actuarial methods and 
assumptions be used over the term of a service provider's participation 
in a plan. Accordingly, a plan may change the actuarial assumptions and 
methods used to determine the life annuity payments provided that all 
of the actuarial assumptions and methods are reasonable.
    (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 plan 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 Sec.  1.409A-1, this section, and 
Sec. Sec.  1.409A-3 through 1.409A-6, 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 (or decrease) in the amount reflects 
reasonable earnings (or losses) through the date the amount is paid. 
For this purpose, a series of installment payments over a predetermined 
period and a series of installment payments over a shorter or longer 
period, or a series of installment payments over the same predetermined 
period but with a different commencement date, are different times and 
forms of payment. Accordingly, a change in the predetermined period or 
the commencement date is a change in the time and form of payment. 
Notwithstanding the foregoing, a schedule of payments does not fail to 
be an installment payment solely because such plan provides for an 
immediate payment of all remaining installments if the present value of 
the deferred amount to be paid in the remaining installment payments 
falls below a predetermined amount, and the immediate payment of such 
amount does not constitute an accelerated payment for purposes of Sec.  
1.409A-3(j), provided that such feature including the predetermined 
amount is established by no later than the time and form of payment is 
otherwise required to be established, and provided further that any 
change in such feature including the predetermined amount is a change 
in the time and form of payment.
    (iv) Transition rule. For purposes of this section, a plan that was 
adopted and effective before December 31, 2007, whether written or 
unwritten, 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, may make such designation on or before December 31, 2007, 
provided such designation is set forth in writing on or before December 
31, 2007.
    (3) Beneficiaries. The rules of this paragraph (b) governing 
changes in the time and form of payment apply to elections by 
beneficiaries with respect to the time and form of payment, as well as 
elections by service providers or service recipients with respect to 
the time and form of payment to beneficiaries. An election to change 
the identity of a beneficiary does not constitute a change in the time 
and form of payment merely because the election changes the identity of 
the recipient of the payment, if the time and form of the payment is 
not otherwise changed. In addition, an election to change the identity 
of a beneficiary before the initial payment of a life annuity does not 
constitute a change in the time and form of payment if the change in 
the time of payments stems solely from the different life expectancy of 
the new beneficiary, such as in the case of a joint and survivor 
annuity.
    (4) Domestic relations orders. The rules of this paragraph (b) 
governing changes in the time and form of payment do not apply to 
elections by individuals other than a service provider, with respect to 
payments to a person other than the service provider, to the extent 
such elections are reflected in, or made in accordance with, the terms 
of a domestic relations order (as defined in section 414(p)(1)(B)).
    (5) Coordination with prohibition against acceleration of payments. 
For purposes of applying the prohibition against the acceleration of 
payments in Sec.  1.409A-3(j), the definition of payment is the same as 
the definition in paragraph (b)(2) of this section. Accordingly, a 
change in the form of a payment that results in a more rapid schedule 
for payments generally will not constitute an acceleration of a 
payment, if the change in the form of payment is made in compliance 
with the subsequent deferral rules. For example, 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 if the change in the form 
of the payment is made in compliance with the requirements of paragraph 
(b)(1) of this section, generally meaning that the election to change 
to a lump-sum payment must be made at least 12 months before the 
installment payments were scheduled to commence and the lump-sum 
payment could not be made until at least five years after the date the 
installment payments were scheduled to commence. See Sec.  1.409A-
3(j)(4)(i) with respect to situations in which the failure to 
accelerate a payment or the

[[Page 19307]]

modification of a plan term relating to certain accelerated payments 
will not be subject to the rules of this paragraph (b).
    (6) 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 or deletion of a permissible payment event to a 
plan under which amounts were previously deferred is subject to the 
rules of this paragraph (b) where the addition or deletion 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(j).
    (7) Delay of payments under certain circumstances. A payment may be 
delayed to a date after the designated payment date under any of the 
circumstances described in this paragraph (b)(7), 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, so long as the service recipient treats 
all payments to similarly situated service providers on a reasonably 
consistent basis.
    (i) Payments subject to section 162(m). A payment may be delayed to 
the extent that the service recipient reasonably anticipates that if 
the payment were made as scheduled, the service recipient's deduction 
with respect to such payment would not be permitted due to the 
application of section 162(m), provided that the payment is made either 
during the service provider's first taxable year in which the service 
recipient reasonably anticipates, or should reasonably anticipate, that 
if the payment is made during such year, the deduction of such payment 
will not be barred by application of section 162(m) or during the 
period beginning with the date of the service provider's separation 
from service and ending on the later of the last day of the taxable 
year of the service recipient in which the service provider separates 
from service or the 15th day of the third month following the service 
provider's separation from service, and provided further that where any 
scheduled payment to a specific service provider in a service 
recipient's taxable year is delayed in accordance with this paragraph, 
the delay in payment will be treated as a subsequent deferral election 
unless all scheduled payments to that service provider that could be 
delayed in accordance with this paragraph are also delayed. Where the 
payment is delayed to a date on or after the service provider's 
separation from service, the payment will be considered a payment upon 
a separation from service for purposes of the rules under Sec.  1.409A-
3(i)(2) (payments to specified employees upon a separation from 
service) and, in the case of a specified employee, the date that is six 
months after a service provider's separation from service is 
substituted for any reference to a service provider's separation from 
service in the first sentence of this paragraph. No election may be 
provided to the service provider with respect to the timing of the 
payment under this paragraph (b)(7)(i).
    (ii) Payments that would violate Federal securities laws or other 
applicable law. A payment may 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 
payment is made at the earliest date at which the service recipient 
reasonably anticipates that the making of the payment will not cause 
such violation. 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.
    (iii) 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 (see Sec.  601.601(d)(2) of this chapter). For 
additional rules applicable to certain delayed payments pursuant to a 
change in control event, see Sec.  1.409A-3(i)(5)(iv). For additional 
rules applicable to amounts payable because of an unforeseeable 
emergency, see Sec.  1.409A-3(i)(3).
    (8) USERRA rights. The requirements of this paragraph (b) are 
deemed met to the extent an election to change the time or form of a 
payment of deferred compensation is provided to satisfy the 
requirements of the Uniformed Services Employment and Reemployment 
Rights Act of 1994, as amended, 38 U.S.C. 4301-4344.
    (9) Examples. The following examples illustrate the application of 
the provisions of this section. For purposes of these examples, each 
employee is an individual with a calendar year taxable year, and is 
employed by the specified employer:

    Example 1. Initial election to defer salary. Employer ZZ 
sponsors a plan under which Employee A may elect to defer a 
percentage of Employee A's salary. Employee A has participated in 
the plan 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. Employer YY has a taxable 
year ending September 30. On July 1, 2008, Employer YY enters into a 
legally binding obligation to pay Employee B a $10,000 bonus. 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). Employer YY does not provide Employee B an election as 
to the time and form of payment. Unless the amount is to be paid in 
accordance with the short-term deferral rule of Sec.  1.409A-
1(b)(4), Employer YY must specify the time and form of payment on or 
before July 1, 2008, to satisfy the requirements of this section.
    Example 3. Initial election to defer bonus payable based on 
services during calendar year. Employer XX has a taxable year ending 
September 30. Employee C participates in a bonus plan under which 
Employee C is entitled to a bonus for services performed during the 
calendar year that, absent an election by Employee C, 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 as described in Sec.  1.409A-1(e). If Employee C 
elects to defer the payment of the bonus with respect to services 
rendered during calendar year 2008, Employee C must elect the time 
and form of payment not later than December 31, 2007, to satisfy the 
requirements of this section.
    Example 4. Initial election to defer bonus payable based on 
services during fiscal year other than calendar year. Employer WW 
has a taxable year ending September 30. Employee D participates in a 
bonus plan under which Employee D is entitled to a bonus for 
services performed during Employer WW's fiscal year that, absent an 
election by Employee D, will be paid on December 15 of the calendar 
year in which 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 D elects to defer 
the payment of the amount related to the fiscal year ending 
September 30, 2009, to satisfy the requirements of this section 
Employee D must elect the time and form of payment not later than 
September 30, 2008.
    Example 5. Initial election to defer bonus payable only if 
service provider completes at least 12 months of services after the 
election. Employer VV has a calendar year taxable year. On March 1, 
2008, Employer VV grants Employee E a $10,000 bonus, payable on

[[Page 19308]]

March 1, 2010 (with reasonable interest), provided that Employee E 
continues performing services as an employee of Employer VV through 
March 1, 2010. The amount does not qualify as performance-based 
compensation as described in Sec.  1.409A-1(e), and Employee E 
already participates in another account balance nonqualified 
deferred compensation plan. Employee E may make an initial deferral 
election on or before March 31, 2008 (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 E does not make an initial deferral election on 
or before March 31, 2008. 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 E 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, 2010 (the first date the payment could become 
substantially vested). Accordingly, Employee E may make an election 
before March 1, 2009, provided that the election defers the payment 
to a date on or after March 1, 2015 (other than a payment due to 
death, disability, unforeseeable emergency, or a change in control 
event).
    Example 7. Initial election to defer sales commissions. Employer 
UU has a calendar year taxable year. As part of Employee F's 
services for Employer UU, Employee F sells refrigerators to 
customers unrelated to Employee F or Employer UU. Under the 
employment arrangement, Employee F is entitled to 10% of the sales 
price of any refrigerator Employee F sells, payable only upon the 
receipt of payment from the customer who purchased the refrigerator. 
For purposes of the initial deferral rule, Employee F is treated as 
performing the services related to each refrigerator sale in the 
calendar year in which each customer pays for the refrigerator.
    Example 8. Initial election to defer renewal sales commissions. 
The same facts as Example 7, except that Employee F 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 F's arrangement with 
Employer UU, Employee F is entitled to 10% 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 election rule, Employee F 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 investment commissions. 
Employer TT is in the trade or business of managing financial assets 
for customer accounts. Customers who deposit funds in an account 
with Employer TT are entitled to remove the account balance of such 
account upon 60 days notice to Employer TT. Employee G sells 
financial products and provides continuing customer service to 
certain unrelated customers involving the deposit and maintenance of 
funds in customer accounts managed by Employer TT. Under the 
employment arrangement, Employee G is entitled to a set percentage 
of the aggregate value of the assets held in the accounts of 
customers to whom Employee G sold financial products and provides 
customer service. Under the arrangement, the aggregate value of the 
assets held in the accounts is determined as of June 30 of each 
year, and unless Employee G elects to defer the payment, the amount 
is payable to Employee G in a lump sum on December 31 of the year in 
which the valuation is made. Employee G has no control over the 
valuation of the assets held in the accounts, or the calculation of 
the amount due Employee G. For purposes of the initial deferral 
rule, Employee G is treated as providing the services to which a 
payment relates during the July 1 through June 30 period ending on 
the June 30 date as of which the assets held in the account are 
valued.
    Example 10. Initial election to defer part-year compensation. 
Employee H provides services as a teacher to Employer SS, a school 
system. The period of services routinely begins on the second Monday 
of August of one year and ends on the first Friday of June of the 
subsequent year. Employer SS provides an election to Employee H to 
receive the compensation for the period of services ratably over the 
period beginning on the second Monday of August of one year and 
ending on the last day of August of the subsequent year. Because the 
compensation constitutes recurring part-year compensation, as 
defined in paragraph (a)(14) of this section, and because the 
schedule will provide that all of the recurring part-year 
compensation is paid no later than September 30 of the subsequent 
year, Employee H will be deemed to have made a timely deferral 
election with respect to such recurring part-year compensation if 
Employee H elects before the first day of the service period to have 
the recurring part-year compensation paid under such schedule.
    Example 11. Initial election to defer negotiated separation pay. 
Employer RR decides to terminate Employee J's employment 
involuntarily. As part of the process of terminating Employee J, 
Employer RR enters into bona fide, arm's length negotiations with 
respect to the terms of Employee J's termination of employment. As 
part of the process, Employer RR offers Employee J an amount that is 
in addition to any amounts to which Employee J is otherwise 
entitled, payable either as a lump sum payment at the end of 3 years 
or in 3 annual payments starting at the date of termination of 
employment. The election of the time and form of payment by Employee 
J may be made at any time before Employee J accepts the offer and 
obtains a legally binding right to the additional amount. The 
election may not apply to any amount to which Employee J already had 
a legally binding right.
    Example 12. Election of time and form of payments under a window 
program. Employer QQ establishes a window program, as defined in 
Sec.  1.409A-1(b)(9)(vi). Individuals who elect to terminate 
employment under the window program are entitled to receive an 
amount equal to 2 weeks pay multiplied by every year of service with 
Employer QQ. 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 3 equal annual 
installments on each January 1 of the first 3 years following the 
election to participate in the window program. Employee K is 
eligible to participate in the window program. Employee K will be 
treated as making a timely deferral election if the election as to 
the time and form of payment is made on or before the date Employee 
K's election to participate in the window program becomes 
irrevocable.
    Example 13. Initial election to defer salary earned during final 
payroll period beginning in one calendar year and ending in the 
subsequent calendar year. Employer PP pays the salary of its 
employees, including Employee L, on a bi-weekly basis. One bi-weekly 
payroll period runs from December 24, 2008, through January 6, 2009, 
with a scheduled payment date of January 13, 2009. Employer PP 
sponsors, and Employee L participates in, a nonqualified deferred 
compensation plan under which Employee L may defer a specified 
percentage of his annual salary. The plan 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 L is deemed to have performed the services for the payroll 
period December 24, 2008, through January 6, 2009, during the 
calendar year 2009.
    Example 14. Application of deferral election rules and anti-
acceleration rules to a nonqualified deferred compensation plan 
linked to a qualified plan. Employee M participates in a qualified 
retirement plan that is a defined benefit plan that offers a 
subsidized early retirement benefit to employees who have attained 
age 55 and completed 30 years of service. Employee M, who has 
attained age 55 and completed 30 years of service, also participates 
in a nonqualified deferred compensation plan, under which the 
benefit payable is calculated under a formula, with that benefit 
then reduced by any benefit that Employee M has accrued under the 
qualified retirement plan. In 2008, Employee M fails to elect the 
subsidized early retirement benefit under the qualified retirement 
plan, with the effect that the amounts payable under the 
nonqualified deferred compensation plan are increased by an amount 
equal to the reduction in the benefit payable under the qualified 
plan. In 2009, Employer NN amends the qualified retirement plan to 
increase benefits under the plan, resulting in a decrease in the 
amounts payable under the nonqualified deferred

[[Page 19309]]

compensation plan equal to the increase in the benefit payable under 
the qualified plan. Neither of these actions constitutes a deferral 
election or an acceleration of a payment under the nonqualified 
deferred compensation plan.
    Example 15. Subsequent deferral election. Employee N 
participates in a nonqualified deferred compensation plan. Employee 
N elects to be paid in a lump sum payment at the earlier of age 65 
or separation from service. Employee N anticipates that he will work 
after age 65, and wishes to defer payment to a later date. Provided 
that Employee N continues in employment and makes the election by 
his 64th birthday, Employee N may elect to receive a lump sum 
payment at the earlier of age 70 or separation from service.
    Example 16. Subsequent deferral election rule--change in form of 
payment from lump sum payment to life annuity. Employee P 
participates in a nonqualified deferred compensation plan. Employee 
P elects to be paid in a lump sum payment at age 65. Employee P 
wishes to change the payment form to a life annuity. Provided that 
Employee P makes the election on or before his 64th birthday, 
Employee P 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 Q 
participates in a nonqualified deferred compensation plan. Employee 
Q elects to be paid in a life annuity at age 65. Employee Q wishes 
to change the payment form to a lump sum payment. Provided that 
Employee Q makes the election on or before his 64th birthday, 
Employee Q may elect to receive a lump sum payment at age 70.
    Example 18. Subsequent deferral election rule--installment 
payments designated as separate payments. Employee R, whose taxable 
year is the calendar year, participates in a nonqualified deferred 
compensation plan 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, 2010. Provided that 
Employee R makes the election on or before January 1, 2009, Employee 
R may elect for the first payment scheduled to be made on January 1, 
2010, to be made on January 1, 2015. If Employee R makes that 
election, but does not elect to defer the remaining payments, the 
remaining payments continue to be due upon January 1 of the 4 
consecutive calendar years commencing on January 1, 2011.
    Example 19. Subsequent deferral election rule--change in form of 
payment from installment payments not designated as separate 
payments to lump sum payment. Employee S participates in a 
nonqualified deferred compensation plan 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, 2010. Employee S wishes to receive the entire 
amount equal to the sum of all 5 of the amounts to be paid as a lump 
sum payment. Provided that Employee S makes the election on or 
before January 1, 2009, Employee S may elect to receive a lump sum 
payment on or after January 1, 2015.
    Example 20. Subsequent deferral election rule--change in form of 
payment from installment payments designated as separate payments to 
lump sum payment. Employee T participates in a nonqualified deferred 
compensation plan that provides for payment in a series of 5 equal 
annual amounts each of which is designated as a separate payment. 
The first amount is scheduled to be paid on January 1, 2010. 
Employee T wishes to receive the entire amount equal to the sum of 
all 5 of the amounts in a single lump sum payment. Provided that 
Employee T makes the election on or before January 1, 2009, Employee 
T may elect to receive a lump sum payment on or after January 1, 
2019.
    Example 21. Subsequent deferral election rule--change in form of 
payment from one life annuity form to another life annuity form. 
Employee U participates in a nonqualified deferred compensation plan 
that permits Employee U to elect before Employee U's separation from 
service whether to be paid in the form of a single life annuity 
beginning on the first day of the month following Employee U's 
separation from service, or an annuity beginning on the first day of 
the month following Employee U's separation from service under which 
annuity payments continue for Employee U's lifetime but not less 
than 10 years. The two types of annuities are actuarially equivalent 
at all times applying reasonable actuarial methods and assumptions. 
For purposes of this section, the two types of annuities are treated 
as a single form of payment. Accordingly, the election provided 
under the plan is not treated as providing a subsequent deferral 
election or accelerated payment, and an election by Employee U under 
the plan between the two annuity options made before the first 
scheduled payment date for an annuity payment is not treated as a 
subsequent deferral election or an acceleration of a payment.
    Example 22. 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 V participates in 
a nonqualified deferred compensation plan that provides for a lump 
sum payment at age 65. Employee V wishes to modify the plan so that 
the deferred amount will be payable upon the later of Employee V's 
attainment of a specified age or separation from service. Provided 
that Employee V makes such election on or before his 64th birthday, 
Employee V may modify the plan so Employee V will receive a lump sum 
payment upon the later of age 70 or separation from service.
    Example 23. Subsequent deferral election rule--change in time of 
payment from payment at separation from service to payment at later 
of separation from service or specified age. Employee W participates 
in a nonqualified deferred compensation plan that provides for a 
lump sum payment at separation from service. Employee W wishes to 
make the payment payable upon the later of separation from service 
or a predetermined age. Provided that Employee W makes such election 
on or before the date 1 year before a separation from service, 
Employee W may elect to receive a lump sum payment upon the later of 
the date 5 years following a separation from service or at a 
specified age.
    Example 24. Subsequent deferral election rule--change in time of 
payment from payment at separation from service to payment at a 
change in control event. Employee X participates in a nonqualified 
deferred compensation plan that provides for a lump sum payment at 
separation from service. Employee X wishes to change the payment 
provision such that the payment is payable upon a change in control 
event. A change in the distribution provision to provide for a 
payment only upon a change in control event will violate the rules 
governing payment provisions, because the change could result in an 
acceleration if the change in control event occurs before Employee X 
separates from service, or a subsequent deferral if the change in 
control does not occur until after Employee X separates from 
service. However, provided that Employee X makes such election on or 
before the date 1 year before a separation from service, Employee X 
may elect to receive a payment upon the later of a change in control 
event or 5 years following a separation from service.

    (c) Special rules for certain resident aliens. For the first 
taxable year of an individual in which such individual is a resident 
alien, a nonqualified deferred compensation plan is deemed to meet the 
requirements of paragraph (a) of this section if, with respect to 
compensation payable for services performed during that first taxable 
year or with respect to compensation the right to which is subject to a 
substantial risk of forfeiture as of the first day of that first 
taxable year, an initial deferral election is made by the end of such 
first taxable year, provided that the initial deferral election may not 
apply to amounts that have already been paid or made available to the 
service provider before the election is made. For any year after the 
first taxable year in which an individual is classified as a resident 
alien, this paragraph (c) does not apply, provided that a taxable year 
may again be treated as the first taxable year in which an individual 
is classified as a resident alien if such individual is classified as a 
resident alien in that taxable year and has not been classified as a 
resident alien for the three consecutive taxable years immediately 
preceding that taxable year.


Sec.  1.409A-3  Permissible payments.

    (a) In general. The requirements of section 409A(a)(2)(A) are met 
only if the plan provides that an amount of deferred compensation under 
the plan may be paid only upon an event or at a time set forth in this 
paragraph (a):
    (1) The service provider's separation from service (as defined in 
Sec.  1.409A-1(h) and in accordance with paragraph (i)(2) of this 
section).

[[Page 19310]]

    (2) The service provider becoming disabled (in accordance with 
paragraph (i)(4) of this section).
    (3) The service provider's death.
    (4) A time or a fixed schedule specified under the plan (in 
accordance with paragraph (i)(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 (i)(5) of this 
section).
    (6) The occurrence of an unforeseeable emergency (in accordance 
with paragraph (i)(3) of this section).
    (b) Designation of payment upon a permissible payment event. Except 
as otherwise specified in this section, a plan provides for the payment 
upon an event described in paragraph (a)(1), (2), (3), (5), or (6) of 
this section if the plan provides the date of the event is the payment 
date, or specifies another payment date that is objectively 
determinable and nondiscretionary at the time the event occurs. A plan 
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 schedule that is objectively determinable and 
nondiscretionary based on the date the event occurs and that would 
qualify as a fixed schedule under paragraph (i)(1) of this section if 
the payment event were instead a fixed date, provided that the schedule 
must be fixed at the time the permissible payment event is designated. 
In addition, a plan may provide that a payment, including a payment 
that is part of a schedule, is to be made during a designated taxable 
year of the service provider that is objectively determinable and 
nondiscretionary at the time the payment event occurs such as, for 
example, a schedule of three substantially equal payments payable 
during the first three taxable years following the taxable year in 
which a separation from service occurs. A plan may also provide that a 
payment, including a payment that is part of a schedule, is to be made 
during a designated period objectively determinable and 
nondiscretionary at the time the payment event occurs, but only if the 
designated period both begins and ends within one taxable year of the 
service provider or the designated period is not more than 90 days and 
the service provider does not have a right to designate the taxable 
year of the payment (other than an election that complies with the 
subsequent deferral election rules of Sec.  1.409A-2(b)). Where a plan 
provides for a period of more than one day following a payment event 
during which a payment may be made, such as within 90 days following 
the date of the event, the payment date for purposes of the subsequent 
deferral rules under Sec.  1.409A-2(b) is treated as the first possible 
date upon which a payment could be made under the terms of the plan. A 
plan may provide for payment upon the earliest or latest of more than 
one event or time, provided that each event or time is described in 
paragraphs (a)(1) through (6) of this section. For examples 
illustrating the provisions of this paragraph, see paragraph (i)(1)(vi) 
of this section.
    (c) Designation of alternative specified dates or payment schedules 
based upon date of permissible event. Except as otherwise provided in 
this paragraph (c), a plan may designate only one time and form of 
payment upon the occurrence of each event described in paragraph 
(a)(1), (2), (3), (5), or (6) of this section. For example, a plan does 
not satisfy the requirements of this paragraph (c) if it provides for 
one payment date or schedule of payments if a specified event occurs on 
a Monday, but another payment date or schedule of payments if the event 
occurs on any other day of the week. However, a plan that provides for 
a payment upon an event described in paragraph (a)(2), (3), (5), or (6) 
of this section may allow for an alternative payment schedule if the 
event occurs on or before one (but not more than one) specified date, 
provided that the addition or deletion of such a different time and 
form of payment applicable to an existing deferral is subject to Sec.  
1.409A-2(b) (subsequent deferral elections) and paragraph (j) of this 
section (accelerated payments). For example, a plan may provide that a 
service provider will receive a lump sum payment of the service 
provider's entire benefit under the plan on the first day of the month 
following a change in control event that occurs before the service 
provider attains age 55, but will receive 5 substantially equal annual 
payments commencing on the first day of the month following a change in 
control event that occurs on or after the service provider attains age 
55. In the case of a plan that provides that a payment upon an event 
described in paragraph (a)(1) of this section (a payment upon a 
separation from service), a different time and form of payment may be 
designated with respect to a separation from service under each of the 
following conditions, provided that the addition or deletion of such a 
different time and form of payment applicable to an existing deferral 
is subject to Sec.  1.409A-2(b) and paragraph (j) of this section:
    (1) A separation from service during a limited period of time not 
to exceed two years following a change in control event (as defined in 
paragraph (i)(5) of this section).
    (2) A separation from service before or after a specified date (for 
example, the attainment of a specified age), or a separation from 
service before or after a combination of a specified date, such as 
attaining a specified age, and a specified period of service determined 
under a predetermined, nondiscretionary, objective formula or pursuant 
to the method for crediting service under a qualified plan sponsored by 
the service recipient.
    (3) A separation from service not described in paragraphs (c)(1) or 
(c)(2) of this section.
    (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 plan (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 taxable year of 
the service provider or, if later, by the 15th day of the third 
calendar month following the date specified under the plan and the 
service provider is not permitted, directly or indirectly, to designate 
the taxable year of the payment. In addition, a payment is treated as 
made upon the date specified under the plan (including a date specified 
under paragraph (a)(4) of this section) and is not treated as an 
accelerated payment if the payment is made no earlier than 30 days 
before the designated payment date and the service provider is not 
permitted, directly or indirectly to designate the taxable year of the 
payment. For purposes of this paragraph, if the date specified is only 
a designated taxable year of the service provider, or a period of time 
during such a taxable year, the date specified under the plan is 
treated as the first day of such taxable year or the first day of the 
period of time during such taxable year, as applicable. The payment 
with respect to a stock right generally occurs upon the exercise of the 
stock right, so that where a stock right designates a fixed exercise 
date, the stock right will be deemed to have been paid at such date if 
the exercise and payment occur on such date or a later date within the 
same taxable year of the service provider or, if later, by the 15th day 
of the third calendar month following the exercise date specified under 
the plan. If calculation of the amount of the payment is not 
administratively practicable due to events beyond the control of the 
service provider (or

[[Page 19311]]

service provider's beneficiary), the payment will be treated as made 
upon the date specified under the plan if the payment is made during 
the first taxable year of the service provider in which the calculation 
of the amount of the payment is administratively practicable. For 
purposes of this paragraph, the inability of a service recipient to 
calculate the amount or timing of a payment due to a failure of a 
service provider (or service provider's beneficiary) to provide 
reasonably available information necessary to make such calculation 
does not constitute an event beyond the control of the service 
provider. Similarly, if the making of the payment at the date specified 
under the plan would jeopardize the ability of the service recipient to 
continue as a going concern, the payment will be treated as made upon 
the date specified under the plan if the payment is made during the 
first taxable year of the service provider in which the making of the 
payment would not have such effect.
    (e) Designation of time and form of payment with respect to 
earnings. A nonqualified deferred compensation plan that provides for 
actual or notional earnings to be credited on amounts of deferred 
compensation may specify, in accordance with the requirements of Sec.  
1.409A-2(a) (initial deferral elections), that such earnings are 
treated separately from the right to the other amounts deferred under 
the plan for purposes of designating the time and form of payments 
under such plan, provided that to satisfy the requirements of this 
paragraph (e), actual or notional earnings must be credited at least 
annually. For these purposes, a right to dividend equivalents may be 
treated analogously to a right to actual or notional earnings on an 
amount of deferred compensation. For purposes of this paragraph (e), 
the term dividend equivalents means the right to an amount equal to all 
or a specified portion of dividends declared and paid, if any, on a 
specified number of shares of stock.
    (f) Substitutions. Except as otherwise provided under these 
regulations, the payment of an amount as a substitute for a payment of 
deferred compensation will be treated as a payment of the deferred 
compensation. A forfeiture or voluntary relinquishment of an amount of 
deferred compensation will not be treated as a payment of the 
compensation, but there is no forfeiture or voluntary relinquishment 
for this purpose if an amount is paid, or a legally binding right to a 
payment is created, that acts as a substitute for the forfeited or 
voluntarily relinquished amount. Whether a payment or a right to a 
payment acts as a substitute for a payment of deferred compensation is 
determined based on all the facts and circumstances. However, where the 
payment of an amount results in an actual or potential reduction of, or 
current or future offset to, an amount of deferred compensation, or if 
the service provider receives a loan the repayment of which is secured 
by or may be accomplished through an offset of or a reduction in an 
amount deferred under a nonqualified deferred compensation plan, the 
payment or loan is a substitute for the deferred compensation. In 
addition, where a service provider's right to deferred compensation is 
made subject to anticipation, alienation, sale, transfer, assignment, 
pledge, encumbrance, attachment, or garnishment by creditors of the 
service provider or the service provider's beneficiary, the deferred 
compensation is treated as having been paid. For the treatment of 
certain offsets, see paragraph (j)(4)(xiii) of this section. Even where 
there is no explicit reduction or offset, the payment of an amount or 
creation of a new right to a payment proximate to the purported 
forfeiture or voluntary relinquishment of a right to deferred 
compensation is presumed to be a substitute for the deferred 
compensation. The presumption is rebuttable by a showing that the 
compensation paid would have been received regardless of the forfeiture 
or voluntary relinquishment of the right to deferred compensation. 
Factors indicating that a payment would have been received regardless 
of such forfeiture or voluntarily relinquishment include that the 
amount paid is materially less than the forfeited or relinquished 
amount, or consists of a type of payment customarily made in the 
ordinary course of business of the service recipient to service 
providers who do not forfeit or relinquish deferred compensation (for 
example, a payment of accrued but unused leave or a payment for a 
release of actual or potential claims). See Sec.  1.409A-1(b)(9)(i) 
with respect to certain separation pay plans.
    (g) Disputed payments and refusals to pay. If a service recipient 
fails to make a payment in whole or in part as of the date specified 
under a plan, either intentionally or unintentionally, other than with 
the express or implied consent of the service provider, the payment 
will be treated as made upon the date specified under the plan 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 relinquishment of the claim to all or part of the remaining 
amount), makes prompt and reasonable, good faith efforts to collect the 
remaining portion of the payment, and any further payment (including 
payment of a lesser amount that satisfies the obligation to make the 
payment) is made no later than the end of the first taxable year of the 
service provider 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 (g), efforts to collect the payment will be presumed not to 
be prompt, reasonable, good faith efforts, unless the service provider 
provides notice to the service recipient within 90 days of the latest 
date upon which the payment could have been timely made in accordance 
with the terms of the plan and these regulations, and unless, if not 
paid, the service provider takes further enforcement measures within 
180 days after such latest date. For purposes of this paragraph (g), a 
service recipient is not treated as having failed 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 (g), the service 
provider is deemed to have requested that a payment not be made, rather 
than the service recipient having failed 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.
    (h) Special rule for certain resident aliens. An agreement, method, 
program, or other 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 taxable year of the service provider in which a service provider 
is a resident alien, and with respect to any

[[Page 19312]]

amount payable in a subsequent taxable year if no later than the last 
day of the first taxable year of the service provider in which the 
service provider is 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 after the first taxable year of an individual in which the 
individual is a resident alien, this paragraph (h) does not apply, 
provided that a taxable year may again be treated as the first taxable 
year in which an individual is a resident alien if such individual has 
not been a resident alien for at least three consecutive taxable years 
immediately preceding the taxable year in which the service provider is 
again a resident alien.
    (i) Definitions and special rules--(1) Specified time or fixed 
schedule--(i) In general. 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 nondiscretionary and 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 at the time payment is 
due pursuant to an objective, nondiscretionary formula specified at the 
time the amount is deferred (for example, 50 percent of a specified 
account balance). Except as otherwise provided in paragraph (i)(1) of 
this section, an amount is not objectively determinable if the amount 
of the payment is based all or in part upon the occurrence of an event, 
including the consummation of a transaction by, or a payment of an 
amount to, a service recipient. If an amount is payable in a service 
provider's taxable year (or pursuant to a fixed schedule of taxable 
years of the service provider) that is designated at the time the 
amount is deferred and that is objectively determinable, the amount is 
treated as payable at a specified time (or pursuant to a fixed 
schedule), 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 the first day 
of the relevant taxable year or years. A specified time or fixed 
schedule also includes the designation at the time the amount is 
deferred of a defined period or periods within the service provider's 
taxable year or taxable years that are objectively determinable, 
provided that no such defined period may begin within one taxable year 
and end within another taxable year, and provided further 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 the first day of the relevant period in which the 
payment will be made. A plan 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 discretionary 
acceleration of the lapse of the substantial risk of forfeiture), 
provided that the schedule must be fixed on the date 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, a 
plan that provides for a bonus payment subject to the condition that 
the service provider complete three years of service, and subject to 
the further condition that such requirement of continued services will 
lapse upon the occurrence of an initial public offering, which 
condition if applied alone would constitute 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).
    (ii) Payment schedules with formula and fixed limitations--(A) 
Individual limitations. A schedule of payments does not fail to be a 
fixed schedule of payments where the amount of a payment or payments 
that may be paid at a specified time or during a specified period is 
limited by an objective nondiscretionary formula or a specified amount 
that is not under the effective control of the service provider and is 
not subject to the exercise of discretion by the service recipient, 
where such limitation is established on or before the date the time and 
form of payment is otherwise required to be set under these 
regulations, and the plan specifies the time and form of any payment 
that will be made or completed after its original payment date due to 
the application of the limitation. A change in the limitation or a 
change in the time and form of any payment that exceeds the limitation 
is subject to the requirements of Sec.  1.409A-2(b) (subsequent 
deferral elections) and paragraph (j) of this section (accelerated 
payments). For purposes of this paragraph, a plan provision that 
reduces a schedule of periodic payments on a dollar-for-dollar basis by 
the amount of Social Security payments received or receivable may be 
treated as a nondiscretionary, objective formula limitation, if such 
reduction does not otherwise affect the time of payment of the deferred 
compensation (other than a forfeiture due to the reduction), including 
changes based on the service provider's eligibility or elections 
related to Social Security benefits. Similarly, a plan provision that 
reduces a schedule of periodic payments on a dollar-for-dollar basis by 
the amount of bona fide disability pay (within the meaning of Sec.  
1.409A-1(a)(5)) received or receivable may be treated as a 
nondiscretionary, objective formula limitation, if the disability 
payments are made pursuant to a plan sponsored by the service recipient 
that covers a substantial number of service providers and was 
established before the service provider became disabled, and if such 
reduction does not otherwise affect the time of payment of the deferred 
compensation (other than a forfeiture due to the reduction). Whether an 
amendment to, or other change in the benefit payable under, such bona 
fide disability plan results in an acceleration of a payment for 
purposes of paragraph (j) of this section or a subsequent election to 
delay the time or change the form of payment for purposes of Sec.  
1.409A-2(b) is determined based on all of the relevant facts and 
circumstances.
    (B) Limitations on aggregate payments to all participants in 
substantially identical plans. A schedule of payments does not fail to 
be a fixed schedule of payments where the amount of the aggregate 
payments that will be made during a specified period of time to all 
participants in substantially identical plans is limited by an 
objective nondiscretionary formula or specified amount that is not 
under the effective control of the service provider and is not subject 
to the exercise of discretion by the service recipient, where the limit 
is established on or before the date the time and form of payment of 
the amount deferred is otherwise required to be set under these 
regulations, the method of allocating payments among the participants 
where there is an overall limitation on the aggregate amount that may 
be paid to a group of service providers during a specified period is an 
objective nondiscretionary allocation method that is not under the 
effective control of the service provider and is not subject to the 
exercise of discretion by the service recipient, the method is 
established on or before the date the time and form of payment of the 
amount deferred is otherwise required to be set,

[[Page 19313]]

and the plan specifies the time and form of any payment of any amount 
that will be paid after its original payment date due to the 
application of the limitation. A change in the limitation or a change 
in the time and form of payment of any payment that is not otherwise 
made at the scheduled payment date due to application of the formula 
limitation is subject the requirements of Sec.  1.409A-2(b) (subsequent 
deferral elections) and paragraph (j) of this section (accelerated 
payments).
    (iii) Payment schedules determined by timing of payments received 
by the service recipient. A payment schedule determined by reference to 
the timing of payments received by the service recipient (not including 
payments from one entity to another entity where both entities are 
treated as part of a single service recipient), meets the requirements 
of a specified date or fixed schedule of payments if the following 
conditions are met:
    (A) The payments due to the service recipient arise from bona fide 
and routine transactions in the ordinary course of business of the 
service recipient.
    (B) The service provider does not have effective control of the 
service recipient, the person from whom such amounts are due, or the 
collection of any of the amounts due to the service recipient.
    (C) The payment schedule provides an objective, nondiscretionary 
method of identification of the payments to the service recipient from 
which the amount of the payment from the service recipient to the 
service provider is determined.
    (D) The payment schedule provides an objective, nondiscretionary 
schedule under which the payments will be made to the service provider.
    (E) The payments to the service recipient from which the amount of 
the payments from service recipient to the service provider are 
determined result from sales of a type that the service recipient is in 
the trade or business of making and makes frequently, and either all 
such sales by the service recipient are taken into account for purposes 
of determining the payment to the service provider, or there is a 
legitimate, non-tax business reason for identifying the specific sales 
taken into account.
    (iv) Reimbursement or in-kind benefit plans--(A) General rule. A 
plan that provides for reimbursements of expenses incurred by a service 
provider, or in-kind benefits, meets the requirements of a specified 
date or fixed schedule of payments with respect to such reimbursements 
or benefits if the following conditions are met:
    (1) The plan provides an objectively determinable nondiscretionary 
definition of the expenses eligible for reimbursement or of the in-kind 
benefits to be provided.
    (2) The plan provides for the reimbursement of expenses incurred or 
for the provision of the in-kind benefits during an objectively and 
specifically prescribed period (including the lifetime of the service 
provider).
    (3) The plan provides that the amount of expenses eligible for 
reimbursement, or in-kind benefits provided, during a service 
provider's taxable year may not affect the expenses eligible for 
reimbursement, or in-kind benefits to be provided, in any other taxable 
year.
    (4) The reimbursement of an eligible expense is made on or before 
the last day of the service provider's taxable year following the 
taxable year in which the expense was incurred.
    (5) The right to reimbursement or in-kind benefits is not subject 
to liquidation or exchange for another benefit.
    (B) Medical reimbursement arrangements. Notwithstanding the 
foregoing, an arrangement providing for the reimbursement of expenses 
referred to in section 105(b) will not be deemed to fail to meet the 
requirements of paragraph (i)(1)(iv)(A)(3) of this section solely 
because the arrangement provides for a limit on the amount of expenses 
that may be reimbursed under such arrangement over some or all of the 
period in which the reimbursement arrangement remains in effect.
    (v) Tax gross-up payments. A plan providing a right to a tax gross-
up payment will be treated as providing for payment at a specified time 
or on a fixed schedule of payments if the plan provides that payment 
will be made, and the payment is made, by the end of the service 
provider's taxable year next following the service provider's taxable 
year in which the service provider remits the related taxes. For 
purposes of this paragraph (i)(1)(v), the term tax gross-up payment 
refers to a payment to reimburse the service provider in an amount 
equal to all or a designated portion of the Federal, state, local, or 
foreign taxes imposed upon the service provider as a result of 
compensation paid or made available to the service provider by the 
service recipient, including the amount of additional taxes imposed 
upon the service provider due to the service recipient's payment of the 
initial taxes on such compensation. In addition, a right to the 
reimbursement of expenses incurred due to a tax audit or litigation 
addressing the existence or amount of a tax liability, whether Federal, 
state, local, or foreign, satisfies the requirement of a fixed time and 
form of payment if the right to the reimbursement provides that payment 
will be made, and the payment is made, by the end of the service 
provider's taxable year following the service provider's taxable year 
in which the taxes that are the subject of the audit or litigation are 
remitted to the taxing authority, or where as a result of such audit or 
litigation no taxes are remitted, the end of the service provider's 
taxable year following the service provider's taxable year in which the 
audit is completed or there is a final and nonappealable settlement or 
other resolution of the litigation. Nothing in this paragraph (i)(1)(v) 
otherwise alters the application of section 409A to the underlying 
compensation arrangement or other arrangement that results in the taxes 
subject to the right to the tax gross-up payment.
    (vi) Examples. The following examples (in which each employee is an 
individual whose taxable year is the calendar year) illustrate the 
principles of paragraphs (a), (b), (c), (d), and (i)(1) of this 
section:

    Example 1.  Employee A provides services as an employee of 
Employer Z, but is not a specified employee. Employee A participates 
in a nonqualified deferred compensation plan providing for a lump 
sum payment payable on or before December 31 of the calendar year in 
which Employee A separates from service. The plan provides for a 
payment upon a separation from service in compliance with this 
section.
    Example 2.  Employee B provides services as an employee of 
Employer Y, but is not a specified employee. Employee B participates 
in a nonqualified deferred compensation plan providing for a lump 
sum payment payable on or before the 90th day immediately following 
the date upon which Employee B separates from service. Employer Y 
retains the sole discretion to determine when during the 90-day 
period the payment will be made. Although the plan does not specify 
a period during one calendar year in which the payment will be made, 
the plan provides for a payment upon a separation from service in 
compliance with this section because the period over which the 
payment may be made is not longer than 90 days.
    Example 3.  Employee C provides services as an employee of 
Employer X, but is not a specified employee. Employee C participates 
in a nonqualified deferred compensation plan providing for a lump 
sum payment payable on or before the 180th day following the date 
upon which Employee C separates from service. Employer X retains the 
sole discretion to determine when during the 180-day period the 
payment will be made. Because the plan does not specify a period 
during one calendar year in which the payment will be made, and 
because the

[[Page 19314]]

period over which the payment may be made is longer than 90 days, 
the plan does not provide for a payment upon a separation from 
service that complies with this section.
    Example 4.  Employee D provides services as an employee of 
Employer W, but is not a specified employee. Employee D participates 
in a nonqualified deferred compensation plan providing for 10 
installment payments payable on the first 10 anniversaries of the 
date Employee D separates from service, provided that no installment 
payment in any year may be more than 1% of Employer W's net income 
for the previous calendar year, and provided further that the excess 
over such limit that would otherwise be payable but is not paid due 
to application of the limit will become payable as of the first 
installment payment date at which time such amount, in combination 
with any installment payment otherwise due Employee D, does not 
exceed 1% of Employer W's net income for the previous calendar year. 
Provided that Employee D does not retain effective control of the 
calculation of Employer W's net income or the amount that Employee D 
will not be paid due to application of the limit, the plan provides 
for a schedule of payments upon a separation from service that 
complies with this section.
    Example 5.  Employee E and Employee F provide services as 
employees of Employer V, but neither is a specified employee. 
Employee E and Employee F both participate in substantially 
identical nonqualified deferred compensation plans providing for 10 
installment payments payable on the first 10 anniversaries of the 
date the respective employee separates from service, provided that 
the total amount of installment payments in any year may not be more 
than 1% of Employer V's net income for the previous year, that where 
any payments are not made due to application of the limit the 
determination of the amount not paid to a particular employee will 
be made by applying the overall limit proportionately based upon the 
installment payment due the employee that year, and that the excess 
over such limit that would otherwise be payable but is not paid due 
to application of the limit will become payable as of the first 
installment payment date at which time such amount, in combination 
with any installment payments otherwise due the participants, does 
not exceed 1% of Employer V's net income for the previous calendar 
year. Provided that neither Employee E nor Employee F retains 
effective control of the calculation of Employer V's net income or 
the amount that the respective employee will not be paid due to 
application of the limit, the plan provides for a schedule of 
payments upon a separation from service that complies with this 
section.
    Example 6. Employee G provides services as an employee of 
Employer U, but is not a specified employee. As a bona fide part of 
this employment relationship, Employee G provides professional 
services to clients of Employer U as part of the bona fide, ordinary 
course of Employer U's trade or business. Under an arrangement 
between Employee G and Employer U, Employer U agrees to pay Employee 
G upon Employee G's separation from service an amount equal to 5% of 
any amount collected from Company T, a client of Employer U for 
which Employee G performed services during his employment with 
Employer U, during the 36 months following Employee G's separation 
from service. Under the arrangement, the amounts due to Employee G 
based upon payments received by Employer U during any calendar year 
are payable to Employee G on April 1 of the subsequent calendar 
year. Provided that Employee G does not have effective control of 
Employer U, Company T, or the collection of any amounts due Employer 
Y from Company T, the arrangement provides for a schedule of 
payments upon a separation from service that complies with this 
section.
    Example 7.  Employee H provides services as an employee of 
Employer S, but is not a specified employee. Under a plan sponsored 
by Employer S, Employee H has a legally binding right upon a 
separation from service to the reimbursement of country club dues 
paid in the calendar year of the separation from service and each of 
the next 3 calendar years following the separation from service in 
an amount not to exceed $30,000 in any calendar year, provided that 
the amount of dues paid in any calendar year that are eligible for 
reimbursement equals only the amount actually expended during such 
calendar year, and the maximum amount available for reimbursement in 
any calendar year will not be increased or decreased to reflect the 
amount expended or reimbursed in a prior or subsequent calendar 
year. The plan further provides that any reimbursement must be paid 
to Employee H by December 31 of the calendar year following the year 
in which Employee H pays the country club dues. The reimbursement 
plan provides for a schedule of payments upon a separation from 
service that complies with this section.
    Example 8.  Employee J provides services as an employee of 
Employer Q, but is not a specified employee. Under a plan sponsored 
by Employer Q, Employee J has a legally binding right upon a 
separation from service to the reimbursement of country club dues 
paid during the calendar year in which the separation from service 
occurs and the next 3 calendar years in a total amount not to exceed 
$90,000. The plan further provides that any reimbursement must be 
paid to Employee J by December 31 of the calendar year following the 
year in which Employee J pays the country club dues. Because the 
reimbursement of a payment of country club dues in one calendar year 
may affect the amount of country club dues available for 
reimbursement in another calendar year, the plan does not provide 
for a schedule of payments upon a separation from service that 
complies with this section.

    (2) Separation from service--required delay in payment to a 
specified employee pursuant to a separation from service--(i) In 
general. In the case of any service provider who is a specified 
employee (as defined in Sec.  1.409A-1(i)) as of the date of a 
separation from service, 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 than 
the end of the six-month period, the date of death of the specified 
employee). For this purpose, a service provider who is not a specified 
employee as of the date of a separation from service will not be 
treated as subject to this requirement even if the service provider 
would have become a specified employee if the service provider had 
continued to provide services through the next specified employee 
effective date. Similarly, a service provider who is treated as a 
specified employee as of the date of a separation from service will be 
subject to this requirement even if the service provider would not have 
been treated as a specified employee after the next specified employee 
effective date had the specified employee continued providing services 
through the next specified employee effective date. Notwithstanding the 
foregoing, this paragraph (i)(2)(i) does not apply to a payment made 
under the circumstances described in paragraph (j)(4)(ii) (domestic 
relations order), (j)(4)(iii) (conflicts of interest), or (j)(4)(vi) 
(payment of employment taxes) of this section.
    (ii) Application of payment rules to delayed payments. The required 
delay in payment is met if 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 on the first day of 
the seventh month following the date of separation from service, or if 
each payment to which a specified employee is otherwise entitled upon a 
separation from service is delayed by six months. A service recipient 
may retain discretion to choose which method will be implemented, 
provided that no direct or indirect election as to the method may be 
provided to the service provider. For an affected specified employee, a 
date upon which the plan or the service recipient designates that the 
payment will be made after the six-month delay is treated as a fixed 
payment date for purposes of paragraph (d) of this section once the 
separation from service has occurred.
    (3) Unforeseeable emergency--(i) Definition. For purposes of 
Sec. Sec.  1.409A-1 and 1.409A-2, this section, and Sec. Sec.  1.409A-4 
through 1.409A-6, an unforeseeable emergency is a severe financial 
hardship to the service provider resulting from an illness or accident 
of the service provider, the service provider's spouse, the service 
provider's beneficiary, or the service provider's dependent (as defined 
in section 152, without regard to section 152(b)(1), (b)(2), and 
(d)(1)(B)); loss of

[[Page 19315]]

the service provider'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. For 
example, the imminent foreclosure of or eviction from the service 
provider'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, a beneficiary, or a 
dependent (as defined in section 152, without regard to section 
152(b)(1), (b)(2), and (d)(1)(B)) may also constitute an unforeseeable 
emergency. Except as otherwise provided in this paragraph (i)(3)(i), 
the purchase of a home and the payment of college tuition are not 
unforeseeable emergencies. Whether a service provider is faced with an 
unforeseeable emergency permitting a distribution under this paragraph 
(i)(3)(i) 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 plan. 
A plan may provide for a payment upon a specific type or types of 
unforeseeable emergency, without providing for 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, local, or 
foreign 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 (j)(4)(viii) of this section. However, the determination 
of amounts reasonably necessary to satisfy the emergency need is not 
required to take into account any additional compensation that due to 
the unforeseeable emergency is available under another nonqualified 
deferred compensation plan but has not actually been paid, or that is 
available due to the unforeseeable emergency under another plan that 
would provide for deferred compensation except due to the application 
of the effective date provisions under Sec.  1.409A-6. The payment may 
be made from any plan in which the service provider participates that 
provides for payment upon an unforeseeable emergency, provided that the 
plan under which the payment was made must be designated at the time of 
payment.
    (iii) Payments due to an unforeseeable emergency. A service 
provider may retain discretion with respect to whether to apply for a 
payment upon an unforeseeable emergency, and a service recipient may 
retain discretion with respect to whether to make a payment available 
under the plan due to an unforeseeable emergency. A service provider 
who has experienced an unforeseeable emergency will not be treated as 
making a subsequent deferral election under Sec.  1.409A-2(b) 
(subsequent deferral election rules) if the service provider does not 
apply for or elect to receive a payment available under the plan. A 
service recipient will not be treated as making a subsequent deferral 
election under Sec.  1.409A-2(b) (subsequent deferral election rules) 
if the service recipient exercises its discretion not to make a payment 
otherwise available due to an unforeseeable emergency.
    (4) Disability--(i) In general. For purposes of Sec. Sec.  1.409A-1 
and 1.409A-2, this section, and Sec. Sec.  1.409A-4 through 1.409A-6, 
except as otherwise specifically provided, 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 
expected 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 three months under an accident and health plan 
covering employees of the service provider's employer.
    (ii) Limited plan definition of disability. A plan 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 plan complies with the provisions of this paragraph 
(i)(4).
    (iii) Determination of disability. A plan may provide that a 
service provider will be deemed disabled if determined to be totally 
disabled by the Social Security Administration or Railroad Retirement 
Board. A plan 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 (i)(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), a 
plan may permit a payment upon the occurrence of a change in the 
ownership of the corporation (as defined in paragraph (i)(5)(v) of this 
section), a change in effective control of the corporation (as defined 
in paragraph (i)(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 (i)(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 or group, such as a plan 
administrator or compensation committee, certify the occurrence of a 
change in control event must be strictly ministerial and not involve 
any discretionary authority. The plan may provide for a payment on a 
particular type or types of change in control events, 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 
plan and pay amounts of deferred compensation upon a change in control 
event, see paragraph (j)(4)(ix)(B) of this section.
    (ii) Identification of relevant corporation--(A) In general. To 
constitute a change in control event with respect to the service 
provider, the change in control event must relate to--

[[Page 19316]]

    (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) but only if either the deferred compensation 
is attributable to the performance of service by the service provider 
for such corporation (or corporations) or there is a bona fide business 
purpose for such corporation or corporations to be liable for such 
payment and, in either case, no significant purpose of making such 
corporation or corporations liable for such payment is the avoidance of 
Federal income tax; or
    (3) A corporation that is a majority shareholder of a corporation 
identified in paragraph (i)(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 (i)(5)(ii)(A)(1) or (2) of this 
section.
    (B) Majority shareholder. For purposes of this paragraph 
(i)(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 (i)(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 unless the sale constitutes a change in the 
ownership of a substantial portion of Corporation A's assets (see 
paragraph (i)(5)(vii) of this section).

    (iii) Attribution of stock ownership. For purposes of paragraph 
(i)(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 rules for certain delayed payments pursuant to a 
change in control event--(A) Certain transaction-based compensation. 
Payments of compensation related to a change in control event described 
in paragraph (i)(5)(v) of this section (change in the ownership of a 
corporation) or paragraph (i)(5)(vii) of this section (change in the 
ownership of a substantial portion of a corporation's assets), that 
occur because a service recipient purchases its stock held by the 
service provider or because the service recipient or a third party 
purchases a stock right held by a service provider, or that are 
calculated by reference to the value of stock of the service recipient 
(collectively, transaction-based compensation), may be treated as paid 
at a designated date or pursuant to a payment schedule that complies 
with the requirements of section 409A if the transaction-based 
compensation is paid on the same schedule and under the same terms and 
conditions as apply to payments to shareholders generally with respect 
to stock of the service recipient pursuant to a change in control event 
described in paragraph (i)(5)(v) of this section (change in the 
ownership of a corporation) or as apply to payments to the service 
recipient pursuant to a change in control event described in paragraph 
(i)(5)(vii) of this section (change in the ownership of a substantial 
portion of a corporation's assets), and to the extent that the 
transaction-based compensation is paid not later than five years after 
the change in control event, the payment of such compensation will not 
violate the initial or subsequent deferral election rules set out in 
Sec.  1.409A-2(a) and (b) solely as a result of such transaction-based 
compensation being paid pursuant to such schedule and terms and 
conditions. If before and in connection with a change in control event 
described in paragraph (i)(5)(v) or (i)(5)(vii) of this section, 
transaction-based compensation that would otherwise be payable as a 
result of such event is made subject to a condition on payment that 
constitutes a substantial risk of forfeiture (as defined in Sec.  
1.409A-1(d), without regard to the provisions of that section under 
which additions or extensions of forfeiture conditions are disregarded) 
and the transaction-based compensation is payable under the same terms 
and conditions as apply to payments made to shareholders generally with 
respect to stock of the service recipient pursuant to a change in 
control event described in paragraph (i)(5)(v) of this section or to 
payments to the service recipient pursuant to a change in control event 
described in paragraph (i)(5)(vii) of this section, for purposes of 
determining whether such transaction-based compensation is a short-term 
deferral the requirements of Sec.  1.409A-1(b)(4) are applied as if the 
legally binding right to such transaction-based compensation arose on 
the date that it became subject to such substantial risk of forfeiture.
    (B) Certain nonvested compensation. Notwithstanding the provisions 
of Sec.  1.409A-1(d) (definition of a substantial risk of forfeiture) 
that disregard the extension or modification of a condition for 
purposes of determining whether a condition on payment constitutes a 
substantial risk of forfeiture, a condition that is a substantial risk 
of forfeiture that otherwise would lapse as a result of a change in 
control event described in paragraph (i)(5)(v) or (i)(5)(vii) of this 
section may be extended or modified before and in connection with such 
event to provide for a condition on payment that will not lapse as a 
result of such change in control event, and such extended or modified 
condition will be treated as continuing to subject the amount to a 
substantial risk of forfeiture, provided that the transaction 
constituting the change in control event is a bona fide arm's length 
transaction between the service recipient or its shareholders and one 
or more parties who are unrelated to the service recipient and service 
provider (applying the rules of Sec.  1.409A-1(f)(2)(ii)) and the 
modified or extended condition to which the payment is subject would 
otherwise be treated as a substantial risk of forfeiture under Sec.  
1.409A-1(d) (without regard to the provisions disregarding additions or 
extensions of forfeiture conditions). In such a case, the continued 
application of a fixed schedule of payments based upon the lapse of the 
substantial risk of forfeiture, so that payments commence upon the 
lapse of the modified or extended condition on payment, will not be 
treated as a change in the fixed schedule of payments for purposes of 
Sec.  1.409A-2(b) (subsequent deferral elections) or paragraph (j) of 
this section (prohibition on the acceleration of payments).
    (v) Change in the ownership of a corporation--(A) In general. 
Except as provided in paragraph (i)(5)(vi)(C) of this section, 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 (i)(5)(v)(B) of this section), acquires ownership of stock of 
the corporation that, together with stock held by such person or group,

[[Page 19317]]

constitutes more than 50 percent of the total fair market value or 
total voting power of the stock of such corporation. A nonqualified 
deferred compensation plan may provide that amounts payable upon a 
change in the ownership of a corporation will be paid only if the 
conditions in the preceding sentence are satisfied but substituting a 
percentage specified in the plan that is higher than 50 percent for the 
words ``50 percent'' in the preceding sentence, but only if the 
provision is set forth in the plan no later than the date by which the 
time and form of payment must be established under Sec.  1.409A-2. 
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 (or such 
higher percentage specified in accordance with the preceding sentence), 
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 (i)(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 (i)(5)(vii) of 
this section for rules regarding the transfer of assets of a 
corporation). See Sec.  1.280G-1, Q&A-27(d), Example 1, Example 2, 
Example 5, and Example 6.
    (B) Persons acting as a group. For purposes of paragraph 
(i)(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 only with respect to the ownership in that 
corporation before 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 3 and Example 4.
    (vi) Change in the effective control of a corporation--(A) In 
general. Notwithstanding that a corporation has not undergone a change 
in ownership under paragraph (i)(5)(v) of this section, a change in the 
effective control of the corporation occurs only on either of the 
following dates:
    (1) The date any one person, or more than one person acting as a 
group (as determined under paragraph (i)(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 30 percent or more of the total 
voting power of the stock of such corporation. A nonqualified deferred 
compensation plan may provide that amounts payable upon an effective 
change in control of a corporation will be paid only if the conditions 
in the preceding sentence are satisfied but substituting a percentage 
specified in the plan that is higher than 30 percent for the word ``30 
percent'' in the preceding sentence, but only if the percentage is set 
forth in the plan no later than the date by which the time and form of 
payment must be established under Sec.  1.409A-2).
    (2) The date 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 before the date of the appointment 
or election, provided that for purposes of this paragraph (i)(5)(vi)(A) 
the term corporation refers solely to the relevant corporation 
identified in paragraph (i)(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 (i)(5)(vi)(A)(2) would 
refer solely to Corporation A. A nonqualified deferred compensation 
plan may provide that amounts payable upon a change in the effective 
control of a corporation will be paid only if the conditions in the 
first sentence of this paragraph are satisfied substituting a portion 
of the members of the corporation's board of directors that is higher 
than the words ``a majority of the members of the corporation's board 
of directors'' in the first sentence of this paragraph, but only if the 
higher portion is set forth in the plan no later than the date by which 
the time and form of payment must be established under Sec.  1.409A-
2(a)).
    (B) Multiple change in control events. A change in effective 
control may occur in a transaction in which one of the two corporations 
involved in the transaction has a change in control event under 
paragraph (i)(5)(v) or (i)(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 (i)(5)(vii) of this 
section and O has a change in effective control under this paragraph 
(i)(5)(vi).
    (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 (i)(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 (i)(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 before 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. 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 (i)(5)(v)(B) of this section), acquires (or has 
acquired during the 12-

[[Page 19318]]

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 
before such acquisition or acquisitions (or such higher amount 
specified by the plan no later than the date by which the time and form 
of payment must be established under Sec.  1.409A-2). 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 (i)(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 (i)(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 (i)(5)(vii)(B)(1)(iii) of this section.
    (2) For purposes of this paragraph (i)(5)(vii)(B) and except as 
otherwise provided in this paragraph (i), 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 that 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 before 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.
    (6) Certain back-to-back arrangements--(i) In general. This 
paragraph (i)(6) applies where a service provider is providing services 
to a service recipient (the intermediate service recipient), who in 
turn is providing services to another service recipient (the ultimate 
service recipient), the services provided by the service provider to 
the intermediate service recipient are closely related to the services 
provided by the intermediate service recipient to the ultimate service 
recipient, there is a nonqualified deferred compensation plan providing 
for payments by the ultimate service recipient to the intermediate 
service recipient (the ultimate service recipient plan), there is a 
nonqualified deferred compensation plan or other agreement, method, 
program, or other arrangement providing for payments of compensation by 
the intermediate service recipient to the service provider (the 
intermediate service recipient plan), and the intermediate service 
recipient plan provides for a payment upon the occurrence of an event 
described in paragraph (a)(1), (2), (3), (5), or (6) of this section. 
In such a case, notwithstanding the generally applicable limits on 
payments in paragraph (a) of this section, the ultimate service 
recipient plan may provide for a payment to the intermediate service 
recipient upon the occurrence of a payment event under the intermediate 
service recipient plan described in paragraph (a)(1), (2), (3), (5), or 
(6) of this section if the time and form of payment is defined as the 
same time and form of payment provided under the intermediate service 
recipient plan, the amount of the payment under the ultimate service 
recipient plan does not exceed the amount of the payment under the 
intermediate service recipient plan, and the ultimate service recipient 
plan and the intermediate service recipient plan otherwise satisfy the 
requirements of section 409A (regardless of whether such plan is 
subject to section 409A).
    (ii) Example. The provisions of paragraph (i)(6)(i) of this section 
are illustrated by the following example:

    Example. Company B (intermediate service recipient) provides 
services to Company C (ultimate service recipient). Employee A 
(service provider) provides services to Company B that are closely 
related to the services Company B provides to Company C. 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 with Company B (the 
intermediate service recipient plan). Under an arrangement between 
Company B and Company C (the ultimate service recipient plan), 
Company C agrees to pay an amount of deferred compensation to 
Company B upon Employee A's separation from service with Company B, 
in accordance with the time, form and amount of payment provided in 
the intermediate service recipient plan. Provided that the 
intermediate service recipient plan and the ultimate service 
recipient plan otherwise comply with the requirements of section 
409A (regardless of whether such arrangements are subject to section 
409A), Company C's payment to Company B of the amount due under the 
ultimate service recipient plan 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.

    (j) Prohibition on acceleration of payments--(1) In general. Except 
as provided in paragraph (j)(4) of this section, 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 
the terms of the plan, and no such accelerated payment may be made 
whether or not provided for under the terms of such plan. For purposes 
of determining whether a payment of deferred compensation has been 
made, the rules of paragraph (f) of this section (substituted payments) 
apply. For purposes of this paragraph (j), 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

[[Page 19319]]

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 plan 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 five 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. However, if the plan 
in this example had provided for a payment at a fixed date, rather than 
at separation from service, the date of payment could not be 
accelerated due to the accelerated vesting. For the definition of a 
payment for purposes of this paragraph (j), see Sec.  1.409A-2(b)(5) 
(coordination of the subsequent deferral election rules with the 
prohibition on acceleration of payments). For other permissible 
payments, see Sec.  1.409A-2(b)(2)(iii) (certain immediate payments of 
remaining installments) and paragraph (d) of this section (certain 
payments made no more than 30 days before the designated payment date).
    (2) Application to multiple payment events. Generally, the addition 
of a permissible payment event, the deletion of a permissible payment 
event, or the substitution of one permissible payment event for another 
permissible payment event, results in an acceleration of a payment if 
the addition, deletion, or substitution could result in the payment 
being made at an earlier date than such payment would have been made 
absent such addition, deletion, or substitution. Notwithstanding the 
previous sentence, the addition of death, disability (as defined in 
paragraph (i)(4) of this section), or an unforeseeable emergency (as 
defined in paragraph (i)(3) of this section), as a potentially earlier 
alternative payment event to an amount previously deferred will not be 
treated as resulting in an acceleration of a payment, even if such 
addition results in the payment being paid at an earlier time than such 
payment would have been made absent the addition of the payment event. 
However, the addition of such a payment event as a potentially later 
alternative payment event generally is subject to the rules governing 
changes in the time and form of payment (see Sec.  1.409A-2(b)).
    (3) Beneficiaries. The rules of this paragraph (j) apply to 
elections by beneficiaries with respect to the time and form of 
payment, as well as elections by service providers or service 
recipients with respect to the time and form of payment to 
beneficiaries. An election to change the identity of a beneficiary does 
not constitute an acceleration of a payment merely because the election 
changes the identity of the recipient of the payment, if the time and 
form of the payment is not otherwise changed. In addition, an election 
before the commencement of a life annuity to change the identity of a 
beneficiary does not constitute an acceleration of a payment if the 
change in the time of payments stems solely from the different life 
expectancy of the new beneficiary, such as in the case of a joint and 
survivor annuity, and does not change the commencement date of the life 
annuity.
    (4) Exceptions--(i) In general. Except as otherwise expressly 
provided, a plan may provide for the acceleration of a payment in 
accordance with paragraphs (j)(4)(ii) through (xiv) of this section, or 
may provide a service recipient discretion to accelerate payments in 
accordance with the provisions of paragraphs (j)(4)(ii) through (xiv) 
of this section. A plan may not provide a service provider discretion 
with respect to whether a payment will be accelerated, and a service 
recipient may not provide a service provider a direct or indirect 
election as to whether the service recipient's discretion to accelerate 
a payment will be exercised, even if such acceleration would be 
permitted under paragraphs (j)(4)(ii) through (xiv) of this section. 
Whether a service recipient has provided a service provider an election 
as to whether the service recipient's discretion to accelerate a 
payment will be exercised is determined based on all the facts and 
circumstances, including whether similarly situated service providers 
have been treated differently. Except as otherwise provided in 
paragraphs (j)(4)(ii) through (xiv) of this section, the plan need not 
set forth the exception in writing, and provided all other requirements 
of this section are met, the making of such a payment or the addition 
of a plan term permitting the making of such a payment will not 
constitute the acceleration of a payment, and the failure to make such 
a payment or the deletion or modification of a plan term permitting the 
making of such a payment will not be subject to the rules regarding a 
change in the time and form of payment under Sec.  1.409A-2(b).
    (ii) Domestic relations order. A plan may provide for acceleration 
of the time or schedule of a payment under the plan to an individual 
other than the service provider, or a payment under such plan may be 
made to an individual other than the service provider, to the extent 
necessary to fulfill a domestic relations order (as defined in section 
414(p)(1)(B)).
    (iii) Conflicts of interest--(A) Compliance with ethics agreements 
with the Federal government. A plan may provide for acceleration of the 
time or schedule of a payment under the plan, or a payment may be made 
under a plan, to the extent necessary for any Federal officer or 
employee in the executive branch to comply with an ethics agreement 
with the Federal government.
    (B) Compliance with ethics laws or conflicts of interest laws. A 
plan may provide for acceleration of the time or schedule of a payment 
under the plan, or a payment may be made under a plan, to the extent 
reasonably necessary to avoid the violation of an applicable Federal, 
state, local, or foreign ethics law or conflicts of interest law 
(including where such payment is reasonably necessary to permit the 
service provider to participate in activities in the normal course of 
his or her position in which the service provider would otherwise not 
be able to participate under an applicable rule). A payment is 
reasonably necessary to avoid the violation of a Federal, state, local, 
or foreign ethics law or conflicts of interest law if the payment is a 
necessary part of a course of action that results in compliance with a 
Federal, state, local, or foreign ethics law or conflicts of interest 
law that would be violated absent such course of action, regardless of 
whether other actions would also result in compliance with the Federal, 
state, local, or foreign ethics law or conflicts of interest law. For 
this purpose, a provision of foreign law is considered applicable only 
to foreign earned income (as defined under section 911(b)(1) without 
regard to section 911(b)(1)(B)(iv) and without regard to the 
requirement that the income be attributable to services performed 
during the period described in section 911(d)(1)(A) or (B)) from 
sources within the foreign country that promulgated such law.

[[Page 19320]]

    (iv) Section 457 plans. A plan subject to section 457(f) may 
provide for an acceleration of the time or schedule of a payment to a 
service provider, or a payment may be made under such a plan, 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.
    (v) Limited cashouts. A plan may require or provide a service 
recipient discretion to require (or be amended to require or to provide 
a service recipient discretion to require), a mandatory lump sum 
payment of amounts deferred under the plan that do not exceed a 
specified amount, provided that such plan term or amendment is executed 
and effective, and any required exercise of service recipient 
discretion is evidenced in writing, no later than the date of such 
payment, and provided that--
    (A) The payment results in the termination and liquidation of the 
entirety of the service provider's interest under the plan, including 
all agreements, methods, programs, or other arrangements with respect 
to which deferrals of compensation are treated as having been deferred 
under a single nonqualified deferred compensation plan under Sec.  
1.409A-1(c)(2); and
    (B) The payment is not greater than the applicable dollar amount 
under section 402(g)(1)(B).
    (vi) Payment of employment taxes. A plan may provide for the 
acceleration of the time or schedule of a payment, or a payment may be 
made under the plan, to pay the Federal Insurance Contributions Act 
(FICA) tax imposed under section 3101, section 3121(a), and section 
3121(v)(2), or the Railroad Retirement Act tax imposed under section 
3201, section 3211, section 3231(e)(1), and section 3231(e)(8), where 
applicable, on compensation deferred under the plan (the FICA or RRTA 
amount). Additionally, a plan may provide for the acceleration of the 
time or schedule of a payment, or a payment may be made under the plan, 
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 or RRTA 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 or RRTA Amount, and the income tax withholding related to such 
FICA or RRTA amount.
    (vii) Payment upon income inclusion under section 409A. A plan may 
provide for the acceleration of the time or schedule of a payment, or a 
payment under such plan may be made, at any time the plan 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 failure to comply with the requirements of section 409A and 
these regulations.
    (viii) Cancellation of deferrals following an unforeseeable 
emergency or hardship distribution. A plan may provide for a 
cancellation of a service provider's deferral election, or such a 
cancellation may be made, due to an unforeseeable emergency or a 
hardship distribution pursuant to Sec.  1.401(k)-1(d)(3). The deferral 
election must be cancelled, not merely postponed or otherwise delayed. 
Accordingly, any later deferral election will be subject to the 
provisions governing initial deferral elections. See Sec.  1.409A-2(a).
    (ix) Plan terminations and liquidations. A plan may provide for the 
acceleration of the time and form of a payment, or a payment under such 
plan may be made, where the acceleration of the payment is made 
pursuant to a termination and liquidation of the plan in accordance 
with one of the following:
    (A) The service recipient's termination and liquidation of the plan 
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. Sec.  
503(b)(1)(A), provided that the amounts deferred under the plan are 
included in the participants' gross incomes in the latest of the 
following years (or, if earlier, the taxable year in which the amount 
is actually or constructively received).
    (1) The calendar year in which the plan termination and liquidation 
occurs.
    (2) The first calendar year in which the amount is no longer 
subject to a substantial risk of forfeiture.
    (3) The first calendar year in which the payment is 
administratively practicable.
    (B) The service recipient's termination and liquidation of the plan 
pursuant to irrevocable action taken by the service recipient within 
the 30 days preceding or the 12 months following a change in control 
event (as defined in paragraph (i)(5) of this section), provided that 
this paragraph will only apply to a payment under a plan if all 
agreements, methods, programs, and other arrangements sponsored by the 
service recipient immediately after the time of the change in control 
event with respect to which deferrals of compensation are treated as 
having been deferred under a single plan under Sec.  1.409A-1(c)(2) are 
terminated and liquidated with respect to each participant that 
experienced the change in control event, so that under the terms of the 
termination and liquidation all such participants are required to 
receive all amounts of compensation deferred under the terminated 
agreements, methods, programs, and other arrangements within 12 months 
of the date the service recipient irrevocably takes all necessary 
action to terminate and liquidate the agreements, methods, programs, 
and other arrangements. Solely for purposes of this paragraph 
(j)(4)(ix)(B), where the change in control event results from an asset 
purchase transaction, the applicable service recipient with the 
discretion to liquidate and terminate the agreements, methods, 
programs, and other arrangements is the service recipient that is 
primarily liable immediately after the transaction for the payment of 
the deferred compensation.
    (C) The service recipient's termination and liquidation of the 
plan, provided that--
    (1) The termination and liquidation does not occur proximate to a 
downturn in the financial health of the service recipient;
    (2) The service recipient terminates and liquidates all agreements, 
methods, programs, and other arrangements sponsored by the service 
recipient that would be aggregated with any terminated and liquidated 
agreements, methods, programs, and other arrangements under Sec.  
1.409A-1(c) if the same service provider had deferrals of compensation 
under all of the agreements, methods, programs, and other arrangements 
that are terminated and liquidated;
    (3) No payments in liquidation of the plan are made within 12 
months of the date the service recipient takes all necessary action to 
irrevocably terminate and liquidate the plan other than payments that 
would be payable under the terms of the plan if the action to terminate 
and liquidate the plan had not occurred;
    (4) All payments are made within 24 months of the date the service 
recipient takes all necessary action to irrevocably terminate and 
liquidate the plan; and
    (5) The service recipient does not adopt a new plan that would be 
aggregated with any terminated and liquidated plan under Sec.  1.409A-
1(c) if the same service provider participated

[[Page 19321]]

in both plans, at any time within three years following the date the 
service recipient takes all necessary action to irrevocably terminate 
and liquidate the plan.
    (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).
    (x) Certain distributions to avoid a nonallocation year under 
section 409(p). A plan may provide for an acceleration of the time and 
form of a payment, or a payment may be made under such plan, to prevent 
the occurrence of a nonallocation year (within the meaning of section 
409(p)(3)) in the plan year of an employee stock ownership plan next 
following the plan year in which such payment is made, 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 (j)(4)(x), synthetic equity (within the meaning of 
section 409(p)(6)(C) and Sec.  1.409(p)-1(f)) granted during the plan 
year of the employee stock ownership plan in which such payment is made 
is disregarded for purposes of determining whether the subsequent plan 
year would result in a nonallocation year.
    (xi) Payment of state, local, or foreign taxes. A plan may provide 
for an acceleration of the time and form of a payment, or a payment may 
be made under such plan, to reflect payment of state, local, or foreign 
tax obligations arising from participation in the plan that apply to an 
amount deferred under the plan before the amount is paid or made 
available to the participant (the state, local, or foreign tax amount). 
Such payment may not exceed the amount of such taxes due as a result of 
participation in the plan. Such payment may be made by distributions to 
the participant in the form of withholding pursuant to provisions of 
applicable state, local, or foreign law or by distribution directly to 
the participant. Additionally, an arrangement may provide for the 
acceleration of the time or schedule of payment, or a payment may be 
made under such arrangement, to pay the income tax at source on wages 
imposed under section 3401 as a result of such payment and to pay the 
additional income tax at source on wages imposed under section 3401 
attributable to such additional section 3401 wages and taxes. However, 
the total payment under this acceleration provision must not exceed the 
aggregate of the state, local, and foreign tax amount, and the income 
tax withholding related to such state, local, and foreign tax amount.
    (xii) Cancellation of deferral elections due to disability. A plan 
may provide for a cancellation of a service provider's deferral 
election, or a cancellation of such election may be made, where such 
cancellation occurs by the later of the end of the taxable year of the 
service provider or the 15th day of the third month following the date 
the service provider incurs a disability. For purposes of this 
paragraph, a disability refers to any medically determinable physical 
or mental impairment resulting in the service provider's inability to 
perform the duties of his or her position or any substantially similar 
position, where such impairment can be expected to result in death or 
can be expected to last for a continuous period of not less than six 
months.
    (xiii) Certain offsets. A plan may provide for the acceleration of 
the time or schedule of a payment, or a payment may be made under such 
plan, as satisfaction of a debt of the service provider to the service 
recipient, where such debt is incurred in the ordinary course of the 
service relationship between the service recipient and the service 
provider, the entire amount of reduction in any of the service 
recipient's taxable years does not exceed $5,000, and the reduction is 
made at the same time and in the same amount as the debt otherwise 
would have been due and collected from the service provider.
    (xiv) Bona fide disputes as to a right to a payment. A plan may 
provide for the acceleration of the time or schedule of one or more 
payments, or a payment may be made under such plan, where such payments 
occur as part of a settlement between the service provider and the 
service recipient of an arm's length, bona fide dispute as to the 
service provider's right to the deferred amount. Discretion to 
accelerate payments, other than due to an arm's length settlement of a 
bona fide dispute as to the service provider's right to the deferred 
amount, is not permitted under this paragraph (j)(4)(xiv). Whether a 
payment qualifies for the exception under this paragraph is based on 
all relevant facts and circumstances. A payment will be presumed not to 
meet this exception unless the payment is subject to a substantial 
reduction in the value of the payment made in relation to the amount 
that would have been payable had there been no dispute as to the 
service provider's right to the payment. For this purpose, a reduction 
that is less than 25 percent of the present value of the deferred 
amount in dispute generally is not a substantial reduction. In 
addition, a payment will be presumed not to meet this exception if the 
payment is made proximate to a downturn in the financial health of the 
service recipient.
    (5) Nonqualified deferred compensation plans linked to qualified 
employer plans or certain other arrangements. If a nonqualified 
deferred compensation plan provides that 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)), 
or a broad-based foreign retirement plan (as defined in Sec.  1.409A-
1(a)(3)(v)) maintained by the service recipient but applied without 
regard to one or more limitations applicable to the qualified employer 
plan under the Internal Revenue Code or to the broad-based foreign 
retirement plan under other applicable law, or that the amount deferred 
under the nonqualified deferred compensation plan is determined as an 
amount offset by some or all of the benefits provided under the 
qualified employer plan or broad-based foreign retirement plan, a 
decrease in amounts deferred under the nonqualified deferred 
compensation plan that results directly from changes in benefit 
limitations applicable to the qualified employer plan or the broad-
based foreign retirement plan under the Internal Revenue Code or other 
applicable law does not constitute an acceleration of a payment under 
the nonqualified deferred compensation plan, 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, and 
provided further that the change in the amounts deferred under the 
nonqualified deferred compensation plan does not exceed such change in 
the amounts deferred under the qualified employer plan or the broad-
based foreign retirement plan, as applicable. In addition, with respect 
to such a nonqualified deferred compensation plan, the following 
actions or failures to act will not constitute an acceleration of a 
payment under the nonqualified deferred compensation plan even if in 
accordance with the terms of the nonqualified deferred compensation 
plan, the actions or inactions result in a decrease in the amounts 
deferred under the plan, provided that such actions or inactions do not 
otherwise affect the time or form of payment under the nonqualified 
deferred compensation plan, and provided further that with respect to 
actions or inactions described in paragraphs (j)(5)(i) and (ii) of this 
section, the change in the amount

[[Page 19322]]

deferred under the nonqualified deferred compensation plan does not 
exceed the change in the amounts deferred under the qualified employer 
plan or the broad-based foreign retirement plan, as applicable:
    (i) A service provider's action or inaction under the qualified 
employer plan or broad-based foreign retirement plan with respect to 
whether to elect to receive a subsidized benefit or an ancillary 
benefit under the qualified employer plan or broad-based foreign 
retirement plan.
    (ii) The amendment of a qualified employer plan or broad-based 
foreign retirement plan to increase benefits provided under such plan, 
or to add or remove a subsidized benefit or an ancillary benefit.
    (iii) A service provider's action or inaction under a qualified 
employer plan with respect to elective deferrals and other employee 
pre-tax contributions subject to the contribution restrictions under 
section 401(a)(30) or section 402(g), including an adjustment to a 
deferral election under such qualified employer plan, provided that for 
any given taxable year, the service provider's action or inaction does 
not result in a decrease in the amounts deferred under all nonqualified 
deferred compensation plans in which the service provider participates 
(other than amounts described in paragraph (j)(5)(iv) of this section) 
in excess of the limit with respect to elective deferrals under section 
402(g)(1)(A), (B), and (C) 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 and other employee 
pre-tax contributions subject to the contributions restrictions under 
section 401(a)(30) or section 402(g), and after-tax contributions by 
the service provider to a qualified employer plan that provides for 
such contributions that affects the amounts that are credited under one 
or more nonqualified deferred compensation plans as matching amounts or 
other similar amounts contingent on such elective deferrals, pre-tax 
contributions, or after-tax contributions, provided that the total of 
such matching or contingent amounts, as applicable, never exceeds 100 
percent of the matching or contingent amounts that would be provided 
under the qualified employer plan absent any plan-based restrictions 
that reflect limits on qualified plan contributions under the Internal 
Revenue Code.
    (6) Changes in elections under a cafeteria plan. A change in an 
election under a cafeteria plan (as defined in section 125(d)) does not 
result in an accelerated payment of an amount deferred under a 
nonqualified deferred compensation plan to the extent that the change 
in the amount deferred under the nonqualified deferred compensation 
plan results solely from the application of the change in amount 
eligible to be treated as compensation under the terms of the 
nonqualified deferred compensation plan resulting from the election 
change under the cafeteria plan, to a benefit formula under the 
nonqualified deferred compensation plan based upon the service 
provider's eligible compensation, and only to the extent that such 
change applies in the same manner as any other increase or decrease in 
compensation would apply to such benefit formula.


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


Sec.  1.409A-5  Funding [Reserved]


Sec.  1.409A-6  Application of section 409A and effective dates.

    (a) Statutory application and effective dates--(1) Application to 
amounts deferred--(i) In general. Except as otherwise provided in this 
section, section 409A applies with respect to amounts deferred in 
taxable years beginning after December 31, 2004, and with respect to 
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. For amounts deferred in taxable years beginning before 
January 1, 2005, under a plan that is materially modified after October 
3, 2004, whether the plan complies with the requirements of section 
409A and these regulations is determined by reference to the terms of 
the plan in effect as of, and any actions taken under the plan on or 
after, the date of the material modification. Section 409A is 
applicable with respect to earnings on amounts deferred only to the 
extent that section 409A is applicable with respect to the amounts 
deferred. Accordingly, section 409A does not apply with respect to 
earnings on amounts deferred before January 1, 2005, unless section 
409A applies with respect to the amounts deferred. For this purpose, a 
right to earnings that is subject to a substantial risk of forfeiture 
(as defined in Sec.  1.83-3(c)) or a requirement to perform further 
services, on an amount deferred that is not subject to a substantial 
risk of forfeiture (as defined in Sec.  1.83-3(c)) or a requirement to 
perform further services, is not treated as earnings on the amount 
deferred, but a separate right to compensation. Except as otherwise 
provided in applicable guidance (see Sec.  601.601(d)(2) of this 
chapter), the provisions of Sec. Sec.  1.409A-1 through 1.409A-5 and 
this section provide the exclusive means of identifying agreements, 
methods, programs, or other arrangements subject to section 409A, and 
the exclusive means of satisfying the requirements of section 409A with 
respect to such agreements, methods, programs, or other arrangements.
    (ii) Collectively bargained plans. Section 409A does not apply with 
respect to amounts deferred under a plan maintained pursuant to one or 
more bona fide collective bargaining agreements in effect on October 3, 
2004, for the period ending on the earlier of the date on which the 
last of such collective bargaining agreements terminates (determined 
without regard to any extension thereof after October 3, 2004) or 
December 31, 2009.
    (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

[[Page 19323]]

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.  1.409A-1(c)(2)(i)(C)), equals the present value of the 
amount to which the service provider would have been entitled under the 
plan if the service provider voluntarily terminated services without 
cause on December 31, 2004, and received a payment of the benefits 
available from the plan on the earliest possible date allowed under the 
plan to receive a payment of benefits following the termination of 
services, and receive the benefits in the form with the maximum value. 
Notwithstanding the foregoing, for any subsequent taxable year of the 
service provider, the grandfathered amount may increase to equal the 
present value of the benefit the service provider actually becomes 
entitled to, in the form and at the time actually paid, 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). For purposes of 
calculating the present value of a benefit under this paragraph 
(c)(3)(i), reasonable actuarial assumptions and methods must be used. 
Whether assumptions and methods are reasonable for this purpose is 
determined as of each date the benefit is valued for purposes of 
determining the grandfathered benefit, provided that any reasonable 
actuarial assumptions and methods that were used by the service 
recipient with respect to such benefit as of December 31, 2004, will 
continue to be treated as reasonable assumptions and methods for 
purposes of calculating the grandfathered benefit. Actuarial 
assumptions and methods will be presumed reasonable if they are the 
same as those used to value benefits under a qualified plan sponsored 
by the service recipient the benefits under which are part of the 
benefit formula under, or otherwise impact the amount of benefits 
under, the nonaccount balance nonqualified deferred compensation plan.
    (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.  1.409A-
1(c)(2)(i)(A)), 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, plus any future contributions to the account, the right to 
which was earned and vested (as defined in paragraph (a)(2) of this 
section) as of December 31, 2004, to the extent such contributions are 
actually made.
    (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 to 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.
    (v) Definition of plan. For purposes of paragraphs (a)(1), (2), and 
(3) of this section, the term ``plan'' has the meaning provided in 
Sec.  1.409A-1(c), except that the plan aggregation rules do not apply 
for purposes of the actuarial assumptions and methods used in paragraph 
(a)(3)(i) of this section. Accordingly, different reasonable actuarial 
assumptions and methods may be used to calculate the amounts deferred 
by a service provider in two different agreements, methods, programs, 
or other 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 to 
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

[[Page 19324]]

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 following 
modifications also are not material modifications for purposes of this 
paragraph (a)(4)(i):
    (A) 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.
    (B) The modification of a provision requiring the immediate 
cancellation of a current deferral election, to require the 
cancellation of deferrals for the same length of time beginning with 
the first date at which the application of such cancellation would not 
violate section 409A (for example, the first date of the service 
provider's first taxable year following the cancellation).
    (C) Compliance with a domestic relations order (as defined in Sec.  
1.409A-3(j)(4)(ii)) with respect to payments to an individual other 
than the service provider, or an amendment to a plan to require 
compliance with a domestic relations order with respect to payments to 
an individual other than the service provider.
    (D) The modification of a plan providing a life annuity form of 
payment to permit an election between the existing life annuity form of 
payment and other forms of annuity payments that would be treated as a 
single form of payment with the existing life annuity form of payment 
under Sec.  1.409A-2(b)(2)(ii).
    (E) The modification of a grandfathered plan to add a limited 
cashout feature consistent with Sec.  1.409A-3(j)(4)(v) (exception to 
prohibition on accelerated payments).
    (ii) Adoptions of new plans. It is presumed that the adoption of a 
new plan or the grant of an additional benefit under an existing plan 
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 plan or grant of the 
additional benefit was 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) of this section and this paragraph 
(a)(4)(ii), the grant of an additional benefit under an existing plan 
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 plan 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 plan 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 a plan to provide 
participants an election whether to terminate participation in a plan 
generally 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.  1.409A-
1(c)(2)(i)(A)), it is not a material modification to change a notional 
investment measure, or to add to an existing investment measure, to 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 taxable 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) Stock rights. The modification, extension, or renewal of a 
stock right will not constitute a material modification of the stock 
right, if the modification, extension, or renewal would not be treated 
as the grant of a new stock right under Sec.  1.409A-1(b)(5)(v)(A), and 
would not result in the stock right being treated as having had a 
deferral feature from the date of grant pursuant to Sec.  1.409A-
1(b)(5)(v)(C).
    (vi) 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 taxable year of the service provider during which such change 
occurred. Thus, for example, if a service recipient modifies the terms 
of a plan on March 1 to allow an individual employee to elect 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 modification before November 1, the plan is 
not considered materially modified under this section.

[[Page 19325]]

    (vii) 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 plan aggregation rules of Sec.  1.409A-1(c)(2) do not 
apply.
    (b) Regulatory applicability date. Sec.  1.409A-1, Sec.  1.409A-2, 
Sec.  1.409A-3 and this section are applicable for taxable years 
beginning on or after January 1, 2008.

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
    Approved: March 20, 2007.
Eric Solomon,
Assistant Secretary of the Treasury.
[FR Doc. 07-1820 Filed 4-10-07; 8:45 am]
BILLING CODE 4830-01-P