As you may already know, the American Jobs Creation Act of 2004 added a new section 409A to the Internal Revenue Code, and a new set of restrictions for nonqualified deferred compensation plans. The scope of the new law is broad, affecting any plan providing for a deferral of compensation, other than certain qualified employer plans, welfare benefit plans and plans specifically excepted in the legislation. However, it is important to note that no exception is granted for Section 457(f) plans and that even split dollar insurance arrangements are affected by the new law.

The long awaited Proposed Treasury Regulations under 409A were released by the IRS in September. With a few significant exceptions outlined below, the regulations extend the deadline for amending nonqualified deferred compensation plans to comply with Code Section 409A to December 31, 2006. The exceptions, which retain a December 31, 2005, deadline, are:

• Year end 2005 deadline for documentation if you allowed 2005 deferral elections as late as March 15, 2005.

If participants were allowed to make new 2005 deferral elections by March 15, 2005 (as permitted under IRS Notice 2005-1), instead of having a deadline of December 31, 2004, you will now need to have in place no later than December 31, 2005:

1. plan amendments reflecting that 2005 deferral elections were permitted as late as March 15, 2005;
2. appropriate changes in your 2005 election form; and
3. Board resolutions reflecting the adoption of the March 15, 2005, deadline and corresponding plan amendments. (IRS Notice 2005-1 allowed the March 15, 2005, deadline and the newly proposed regulations under Section 409A do not change it, but plans using this deadline will need to document it by December 31, 2005.)

• Year end 2005 deadline for documentation and complete distribution if you have terminations of participation or cancellations of outstanding deferral elections.

The proposed regulations do not change the December 31, 2005, deadline [also permitted under IRS Notice 2005-1, pursuant to authority granted under Code Section 409A(f)] for termination of participation in a plan or cancellation of outstanding deferral elections pertaining to compensation earned after December 31, 2004. Board resolutions and plan amendments to permit termination or cancellation of elections must be in place by December 31, 2005, if the choice is made to allow termination or cancellation of elections by December 31, 2005. Also, termination or cancellation forms must be completed and the deferrals completely distributed by December 31, 2005.

• 2006 deferral elections must be made by year end.

Under the general rules of Code Section 409A, elections to defer 2006 compensation must be made by December 31, 2005, but elections as to the time and form of 2006 deferrals need not be made until December 31, 2006, under transition relief granted in IRS Notice 2005-1 and extended to December 31, 2006, under the newly proposed regulations. Accordingly, with respect to deferrals of 2006 compensation, election forms must be made available and elections made by December 31, 2005, although the deadline for elections as to time and form is December 31, 2006. (Note that although the December 31, 2005, deadline for initial deferral of 2006 compensation is the general rule, there are a few special circumstances under Section 1.409A-2 of the proposed regulations that allow for initial deferral elections of 2006 compensation after December 31, 2005, such as a thirty-day time period for deferrals by service providers who first become eligible to participate in a plan during 2006, a "six months before the end of the performance period" deadline for service providers who receive performance based compensation, a special rule for fiscal year service recipients, and so on.)

• Year end deadline for termination and complete distribution of grandfathered plans.

Grandfathered plans can be terminated and monies distributed by December 31, 2005, without the accelerated distribution being characterized as a material modification, but this must be documented by Board resolutions and plan amendments, and all monies must be distributed by December 31, 2005.

• Watch out for year end deadline if discounted stock options or discounted stock appreciation rights are to be replaced with cash or vested property.

The deadline for replacing discounted stock options and stock appreciation rights ("SARs") with fair market value options and fair market value SARs is extended to December 31, 2006, in the proposed IRS regulations under Section 409A, but if the discounted stock option or SAR is to be replaced with cash or vested property, this is a cancellation of deferral and the deadline remains December 31, 2005. The December 31, 2005 deadline may be especially important for companies offering options or SARs on stock other than their own because the Section 409A exceptions for fair market value stock options and SARs only apply to "service recipient" stock options and SARs as defined therein.

• If you inadvertently made a material modification in 2005, rescission opportunity may be available, but only until year end.

Service recipients with existing nonqualified deferred compensation plans who made a material modification in 2005 and now do not plan to terminate and distribute completely by December 31, 2005, have to rescind the material modification by December 31, 2005, to avoid application of 409A to amounts deferred and vested before 2005.

The following points are very important because although they do not have December 31, 2005, deadlines, they affect the operation of nonqualified deferred compensation plans on an ongoing basis:

• Identify key employees.

Even though identification of key employees is not required by year end 2005, if key employees of publicly traded companies separate from service in 2006, 409A and the regulations only classify deferred compensation as a "permitted payment" (as defined therein) if the deferred compensation is paid no earlier than six months from the date of separation from service of the key employee. Publicly traded companies will need to identify key employees (and the definition under 409A is not simple) now in anticipation of separations from service in 2006.

• Update your withholding practices, W-2s and 1099s.

The newly proposed regulations require deferred compensation to be reflected on W-2s and 1099s. Deferred compensation payments are also subject to withholding under Code Section 409A. Even though this is not something that must be done by December 31, 2005, you should get ready to modify your withholding practices and your procedures for preparation of Forms W-2 and 1099 to comply with these requirements in 2006.

• Remember that good faith compliance is an ongoing requirement.

The ‘good faith’ compliance requirement of IRS Notice 2005-1 is retained in the newly proposed regulations under Section 409A. This means that although the deadline for many amendments to comply with 409A is December 31, 2006, there are many actions prohibited under the regulations that can cost a plan its good faith compliance and result in inclusion of income for service providers, plus interest at the underpayment rate plus 1%, and a 20% additional tax on the amount required to be included in income. For example, if a plan allows a so-called "haircut" provision, (a haircut provision allows a service provider to accelerate previously deferred compensation in exchange for a percentage reduction in the amount to be received), then the plan may be amended as late as December 31, 2006, to remove the haircut provision without violating Section 409A. If, during 2006, however, a service provider requests a "haircut payment" as allowed under the plan prior to its amendment, and the service recipient makes the payment less the percentage "haircut," then the good faith compliance is lost as to that service provider, and the income inclusion, interest and 20% tax apply. Accordingly, even though the amendment deadline is December 31, 2006, clients with nonqualified deferred compensation plans need to be informed that actions contrary to Section 409A cannot be taken without potential loss of good faith compliance (with consequent income inclusion, interest and the twenty percent penalty), even if at the time the action was taken the plan still allowed it because the December 31, 2006, deadline for amendments had not passed. This makes it all the more important that you contact your advisors now to avoid an inadvertent and costly mistake in administering your nonqualified deferred compensation plans.

• Don't forget SEC requirements.

For example, the SEC requires reporting of a newly established plan or material amendments of existing plans of public companies within four days. The SEC also requires that the plan or amendment be filed either with the initial filing or in a Company's next periodic report. NYSE and NASDAQ corporate governance rules and shareholder approval requirements may also be a consideration.

The author presents these materials with the understanding that the information provided is not legal advice. Due to the rapidly changing nature of the law, information contained in this publication may become outdated. Anyone using these materials should always research original sources of authority and update this information to ensure accuracy when dealing with a specific matter. No person should act or rely upon the information contained in this publication without seeking the advice of an attorney.

Circular 230 Notice: With respect to federal tax issues, no advice, statement or information contained in this communication is intended to be, or written for the purpose of being, (a) relied upon by a taxpayer as the exclusive basis to avoid penalties under the Internal Revenue Code, or (b) used in connection with the promotion, marketing or recommendation of any tax shelter product or tax shelter transaction.