57930 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

DEPARTMENT OF THE TREASURY 

Internal Revenue Service 

26 CFR Part 1 

[REG–158080–04] 

RIN 1545–BE79 

Application of Section 409A to 

Nonqualified Deferred Compensation 

Plans 

AGENCY: Internal Revenue Service (IRS), 

Treasury. 

ACTION: Notice of proposed rulemaking 

and notice of public hearing. 

SUMMARY: This document contains 

proposed regulations regarding the 

application of section 409A to 

nonqualified deferred compensation 

plans. The regulations affect service 

providers receiving amounts of deferred 

compensation, and the service 

recipients for whom the service 

providers provide services. This 

document also provides a notice of 

public hearing on these proposed 

regulations. 

DATES: Written or electronic comments 

must be received by January 3, 2006. 

Outlines of topics to be discussed at the 

public hearing scheduled for January 25, 

2006, must be received by January 4, 

2006. 

ADDRESSES: Send submissions to: 

CC:PA:LPD:PR (REG–158080–04), room 

5203, Internal Revenue Service, PO Box 

7604, Ben Franklin Station, Washington, 

DC 20044. Submissions may be handdelivered Monday through Friday 

between the hours of 8 a.m. and 4 p.m. 

to CC:PA:LPD:PR (REG–158080–04), 

Courier’s Desk, Internal Revenue 

Service, 1111 Constitution Avenue, 

NW., Washington, DC or sent 

electronically, via the IRS Internet site 

at www.irs.gov/regs or via the Federal 

eRulemaking Portal at 

www.regulations.gov (IRS REG–158080– 

04). The public hearing will be held in 

the Auditorium, Internal Revenue 

Building, 1111 Constitution Avenue, 

NW., Washington, DC. 

FOR FURTHER INFORMATION CONTACT: 

Concerning the proposed regulations, 

Stephen Tackney, at (202) 927–9639; 

concerning submissions of comments, 

the hearing, and/or to be placed on the 

building access list to attend the 

hearing, Richard A. Hurst at (202) 622– 

7116 (not toll-free numbers). 

SUPPLEMENTARY INFORMATION: 

Background 

Section 409A was added to the 

Internal Revenue Code (Code) by section 

885 of the American Jobs Creation Act 

of 2004, Public Law 108–357 (118 Stat. 

1418). Section 409A generally provides 

that unless certain requirements are 

met, amounts deferred under a 

nonqualified deferred compensation 

plan for all taxable years are currently 

includible in gross income to the extent 

not subject to a substantial risk of 

forfeiture and not previously included 

in gross income. Section 409A also 

includes rules applicable to certain 

trusts or similar arrangements 

associated with nonqualified deferred 

compensation, where such 

arrangements are located outside of the 

United States or are restricted to the 

provision of benefits in connection with 

a decline in the financial health of the 

sponsor. 

On December 20, 2004, the IRS issued 

Notice 2005–1 (2005–2 I.R.B. 274 

(published as modified on January 6, 

2005)), setting forth initial guidance 

with respect to the application of 

section 409A, and supplying transition 

guidance in accordance with the terms 

of the statute. Notice 2005–1 requested 

comments on all aspects of the 

application of Section 409A, including 

certain specified topics. Numerous 

comments were submitted and all were 

considered by the Treasury Department 

and the IRS in formulating these 

regulations. In general, these regulations 

incorporate the guidance provided in 

Notice 2005–1 and provide substantial 

additional guidance. For a discussion of 

the continued applicability of Notice 

2005–1, see the Effect on Other 

Documents section of this preamble. 

Explanation of Provisions 

I. Definition of Nonqualified Deferred 

Compensation Plan 

A. In General 

Section 409A applies to amounts 

deferred under a nonqualified deferred 

compensation plan. For this purpose a 

nonqualified deferred compensation 

plan means any plan that provides for 

the deferral of compensation, with 

specified exceptions such as qualified 

retirement plans, tax-deferred annuities, 

simplified employee pensions, SIMPLEs 

and section 501(c)(18) trusts. In 

addition, section 409A does not apply to 

certain welfare benefit plans, including 

bona fide vacation leave, sick leave, 

compensatory time, disability pay, and 

death benefit plans. 

In certain instances, these regulations 

cross reference the regulations under 

section 3121(v)(2), which provide a 

special timing rule under the Federal 

Insurance Contributions Act (FICA) for 

nonqualified deferred compensation, as 

defined in section 3121(v)(2) and the 

regulations thereunder. However, unless 

explicitly cross-referenced in these 

regulations, the regulations under 

section 3121(v)(2) do not apply for 

purposes of section 409A and under no 

circumstances do these proposed 

regulations affect the application of 

section 3121(v)(2). 

B. Section 457 Plans 

Section 409A does not apply to 

eligible deferred compensation plans 

under section 457(b). However, section 

409A applies to nonqualified deferred 

compensation plans to which section 

457(f) applies, separately and in 

addition to the requirements applicable 

to such plans under section 457(f). 

Section 409A(c) provides that nothing 

in section 409A prevents the inclusion 

of amounts in gross income under any 

other provision of the Code. Section 

409A(c) further provides that any 

amount included in gross income under 

section 409A will not be required to be 

included in gross income under any 

other Code provision later than the time 

provided in section 409A. Accordingly, 

if in a taxable year an amount subject to 

section 409A (but not required to be 

included in income under section 409A) 

is required to be included in gross 

income under section 457(f), that 

amount must be included in gross 

income under section 457(f) for that 

taxable year. Correspondingly, if in a 

taxable year an amount that would 

otherwise be required to be included in 

gross income under section 457(f) has 

been included previously in gross 

income under section 409A, that 

amount will not be required to be 

included in gross income under section 

457(f) for that taxable year. 

These proposed regulations are 

intended solely as guidance with 

respect to the application of section 

409A to such arrangements, and should 

not be relied upon with respect to the 

application of section 457(f). Thus, State 

and local government and tax exempt 

entities may not rely upon the definition 

of a deferral of compensation under 

§ 1.409A–1(b) of these proposed 

regulations in applying section 457(f). 

For example, for purposes of section 

457(f), a deferral of compensation 

includes a stock option and an 

arrangement in which an employee or 

independent contractor of a state or 

local government or tax-exempt entity 

earns the right to future payments for 

services, even if those amounts are paid 

immediately upon vesting and would 

qualify for the exclusion from the 

definition of deferred compensation 

under § 1.409A–1(b)(5) of these 

proposed regulations. However, until 

further guidance is issued, State and 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57931 

local government and tax exempt 

entities may rely on the definitions of 

bona fide vacation leave, sick leave, 

compensatory time, disability pay, and 

death benefit plans for purposes of 

section 457(f) as applicable for purposes 

of applying section 409A and § 1.409A–

1(a)(4) of these proposed regulations to 

nonqualified deferred compensation 

plans under section 457(f). 

C. Arrangements With Independent 

Contractors 

Consistent with Notice 2005–1, Q&A–

8, these regulations exclude from 

coverage under section 409A certain 

arrangements between service providers 

and service recipients. Under these 

regulations, amounts deferred in a 

taxable year with respect to a service 

provider using an accrual method of 

accounting for that year are not subject 

to section 409A. In addition, section 

409A generally does not apply to 

amounts deferred pursuant to an 

arrangement between a service recipient 

and an unrelated independent 

contractor (other than a director of a 

corporation), if during the independent 

contractor’s taxable year in which the 

amount is deferred, the independent 

contractor is providing significant 

services to each of two or more service 

recipients that are unrelated, both to 

each other and to the independent 

contractor. In response to comments, 

these regulations clarify that the 

determination is made based upon the 

independent contractor’s taxable year in 

which the amount is deferred. 

Commentators also requested 

clarification of the circumstances in 

which services to each service recipient 

will be deemed to be significant, as 

required for the exclusion. Determining 

whether services provided to a service 

recipient are significant generally will 

involve an examination of all relevant 

facts and circumstances. However, two 

clarifications have been provided. First, 

the analysis applies separately to each 

trade or business in which the service 

provider is engaged. For example, a 

taxpayer providing computer 

programming services for one service 

recipient will not meet the exception if, 

as a separate trade or business, the 

taxpayer paints houses for another 

unrelated service recipient. To provide 

certainty to many independent 

contractors engaged in an active trade or 

business with multiple service 

recipients, a safe harbor has been 

provided under which an independent 

contractor with multiple unrelated 

service recipients, to whom the 

independent contractor also is not 

related, will be treated as providing 

significant services to more than one of 

those service recipients, if not more 

than 70 percent of the total revenue 

generated by the trade or business in the 

particular taxable year is derived from 

any particular service recipient (or 

group of related service recipients). 

Commentators also requested 

clarification with respect to the 

application of section 409A to directors. 

As provided in these regulations, an 

individual will not be excluded from 

coverage under section 409A merely 

because the individual provides services 

as a director to two or more unrelated 

service recipients. However, the 

provisions of section 409A apply 

separately to arrangements between the 

service provider director and each 

service recipient. Accordingly, the 

inclusion of income due to a failure to 

meet the requirements of section 409A 

with respect to an arrangement to serve 

as a director of one service recipient 

will not cause an inclusion of income 

with respect to arrangements to serve as 

a director of an unrelated service 

recipient. In addition, the continuation 

of services as a director with one service 

recipient will not cause the termination 

of services as a director with an 

unrelated service recipient to fail to 

constitute a separation from service for 

purposes of section 409A, if the 

termination would otherwise qualify as 

a separation from service. 

Commentators also requested 

clarification with respect to the 

application of the rule to directors who 

are also employees of the service 

recipient. In general, the provisions of 

section 409A will apply separately to 

the arrangements between the service 

recipient and the service provider for 

services as a director and the 

arrangements between the service 

recipient and the service provider for 

services as an employee. However, the 

distinction is not intended to permit 

employee directors to limit the 

aggregation of arrangements in which 

the individual participates as an 

employee by labeling such arrangements 

as arrangements for services as a 

director. Accordingly, an arrangement 

with an employee director will be 

treated as an arrangement for services as 

a director only to the extent that another 

non-employee director defers 

compensation under the same, or a 

substantially similar, arrangement on 

similar terms. Moreover, the separate 

application of section 409A to 

arrangements for services as a director 

and arrangements for services as an 

employee does not extend to a service 

provider’s services for the service 

recipient as an independent contractor 

in addition to the service provider’s 

services as a director of the service 

recipient. Under those circumstances, 

both arrangements are treated as 

services provided as an independent 

contractor. 

Commentators also requested 

clarification of the application of the 

exclusion to independent contractors 

who provide services to only one 

service recipient, when that service 

recipient itself has multiple clients. 

Specifically a commentator requested 

that the rule be applied on a look 

through basis, so that the independent 

contractor will be deemed to be 

providing services for multiple service 

recipients. The Treasury Department 

and the IRS do not believe that such a 

rule is appropriate. Where multiple 

persons have come together and formed 

an entity that is itself a service recipient 

of the independent contractor, the 

independent contractor is performing 

services for the single entity service 

recipient. 

The Treasury Department and the IRS 

believe that where the service recipient 

is purchasing an independent 

contractor’s management services, 

amounts deferred with respect to the 

independent contractor’s performance 

of services should not be excluded from 

coverage under section 409A. Among 

the many objectives underlying the 

enactment of section 409A is to limit the 

ability of a service provider to retain the 

benefits of the deferral of compensation 

while having excessive control over the 

timing of the ultimate payment. Where 

the independent contractor is managing 

the service recipient, there is a 

significant potential for the independent 

contractor to have such influence or 

control over compensation matters so 

that categorical exclusion from coverage 

under section 409A is not appropriate. 

Accordingly, the regulations provide 

that compensation arrangements 

between an independent contractor and 

a service recipient that involve the 

provision of management services are 

not excluded from coverage under 

section 409A, and in such cases, the 

service recipient is not treated as 

unrelated for purposes of determining 

whether arrangements with other 

service recipients are excluded from 

coverage under section 409A under the 

general rule addressing independent 

contractors providing services to 

multiple unrelated service recipients. 

For this purpose, management services 

include services involving actual or de 

facto direction or control of the financial 

or operational aspects of the client’s 

trade or business, or investment 

advisory services that are integral to the 

trade or business of a service recipient 

whose primary trade or business 

involves the management of 

57932 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

investments in entities other than the 

entities comprising the service 

recipient, such as a hedge fund or real 

estate investment trust. 

II. Definition of Nonqualified Deferred 

Compensation 

A. In General 

Consistent with Notice 2005–1, Q&A–

4, these regulations provide that a plan 

provides for the deferral of 

compensation only if, under the terms 

of the plan and the relevant facts and 

circumstances, the service provider has 

a legally binding right during a taxable 

year to compensation that has not been 

actually or constructively received and 

included in gross income, and that, 

pursuant to the terms of the plan, is 

payable to (or on behalf of) the service 

provider in a later year. A legally 

binding right to compensation may exist 

even where the right is subject to 

conditions, including conditions that 

constitute a substantial risk of forfeiture. 

For example, an employee that in Year 

1 is promised a bonus equal to a set 

percentage of employer profits, to be 

paid out in Year 3 if the employee has 

remained in employment through Year 

3, has a legally binding right to the 

payment of the compensation, subject to 

the conditions being met. The right thus 

may be subject to a substantial risk of 

forfeiture, and accordingly be 

nonvested; however, the promise 

constitutes a legally binding right 

subject to a condition. 

In contrast, a service provider does 

not have a legally binding right to 

compensation if that compensation may 

be unilaterally reduced or eliminated by 

the service recipient or other person 

after the services creating the right to 

the compensation have been performed. 

Notice 2005–1, Q&A–4 provides that, if 

the facts and circumstances indicate 

that the discretion to reduce or 

eliminate the compensation is available 

or exercisable only upon a condition 

that is unlikely to occur, or the 

discretion to reduce or eliminate the 

compensation is unlikely to be 

exercised, a service provider will be 

considered to have a legally binding 

right to the compensation. 

Commentators criticized the provision 

as being difficult to apply, because the 

standard is too vague, requiring a 

subjective judgment as to whether the 

discretion is likely to be exercised. The 

intent of this provision was to eliminate 

the possibility of taxpayers avoiding the 

application of section 409A through the 

use of plan provisions providing 

negative discretion, where such 

provisions are not meaningful. In 

response to the comments, these 

regulations adopt a standard under 

which the negative discretion will be 

recognized unless it lacks substantive 

significance, or is available or 

exercisable only upon a condition. 

Thus, where a promise of compensation 

may be reduced or eliminated at the 

unfettered discretion of the service 

recipient, that promise generally will 

not result in a legally binding right to 

compensation. However, where the 

negative discretion lacks substantive 

significance, or the discretion is 

available or exercisable only upon a 

condition, the discretion will be ignored 

and the service provider will be treated 

as having a legally binding right. In 

addition, where the service provider has 

control over, or is related to, the person 

granted the discretion to reduce or 

eliminate the compensation, or has 

control over all or any portion of such 

person’s compensation or benefits, the 

discretion also will be ignored and the 

service provider will be treated as 

having a legally binding right to the 

compensation. 

B. Short-Term Deferrals 

Notice 2005–1, Q&A–4(c), set forth an 

exception from coverage under section 

409A under which certain 

arrangements, referred to as short-term 

deferrals, would not be treated as 

resulting in the deferral of 

compensation. Specifically, Notice 

2005–1, Q&A–4 provided that until 

further guidance a deferral of 

compensation would not occur if, 

absent an election to otherwise defer the 

payment to a later period, at all times 

the terms of the plan require payment 

by, and an amount is actually or 

constructively received by the service 

provider by, the later of (i) the date that 

is 21⁄2 months from the end of the 

service provider’s first taxable year in 

which the amount is no longer subject 

to a substantial risk of forfeiture, or (ii) 

the date that is 21⁄2 months from the end 

of the service recipient’s year in which 

the amount is no longer subject to a 

substantial risk of forfeiture. For these 

purposes, an amount that is never 

subject to a substantial risk of forfeiture 

is considered to be no longer subject to 

a substantial risk of forfeiture on the 

date the service provider first has a 

legally binding right to the amount. 

Under this rule, many multi-year bonus 

arrangements that require payments 

promptly after the amount vests would 

not be subject to section 409A. 

The exception from coverage under 

section 409A for short-term deferrals set 

forth in Notice 2005–1, Q&A–4, has 

been incorporated into these proposed 

regulations. Commentators questioned 

whether a written provision in the 

arrangement requiring the payment to 

be made by the relevant deadline is 

necessary, or whether the customary 

practice of the service recipient is 

sufficient. These regulations do not 

require that the arrangement provide in 

writing that the payment must be made 

by the relevant deadline. Accordingly, 

where an arrangement does not 

otherwise defer compensation, an 

amount will qualify as a short-term 

deferral, and not be subject to section 

409A, if the amount is actually paid out 

by the appropriate deadline. However, 

where an arrangement does not provide 

in writing that a payment must be paid 

by a specified date on or before the 

relevant deadline, and the payment is 

not made by the appropriate deadline 

(except due to unforeseeable 

administrative or solvency issues, as 

discussed below), the payment will 

result in automatic violation of section 

409A due to the failure to specify the 

payment date or a permissible payment 

event. In addition, the rules permitting 

the service recipient limited discretion 

to delay payments of amounts subject to 

section 409A (for example, where the 

service recipient reasonably anticipates 

that payment of the amount would not 

be deductible due to application of 

section 162(m), or where the service 

recipient reasonably anticipates that 

payment of the amount would violate a 

loan covenant or similar contractual 

provision) would not be available, 

because the arrangement would not 

have specified a payment date subject to 

the delay. In contrast, where an 

arrangement provides in writing that a 

payment must be made by a specified 

date on or before the relevant deadline, 

and the payment is not made by the 

appropriate deadline so that section 

409A becomes applicable, the rules 

contained in these regulations generally 

permitting the payment to be made in 

the same calendar year as the fixed 

payment date become applicable. In 

addition, the rules permitting a plan to 

provide for a delay in the payment in 

certain circumstances and the relief 

applicable to disputed payments and 

refusals to pay would also be available. 

Accordingly, it will often be appropriate 

to include a date or year for payment 

even when it is intended that the 

payment will be made within the shortterm deferral period. 

The short-term deferral rule does not 

provide a method to avoid application 

of section 409A if the legally binding 

right creates a right to deferred 

compensation from the outset. For 

example, if a legally binding right to 

payment in Year 10 arises in Year 1, but 

the right is subject to a substantial risk 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57933 

of forfeiture through Year 3, paying the 

amount at the end of Year 3 would not 

result in the payment failing to be 

subject to section 409A, but rather 

generally would be an impermissible 

acceleration of the payment from the 

originally established right to payment 

in year 10. 

Commentators also questioned 

whether the 21⁄2 month deadline for 

payment could be extended where the 

payment was not administratively 

practicable, or where the payment was 

made late due to error. These 

regulations provide that a payment 

made after the 21⁄2 month deadline may 

continue to be treated as meeting the 

requirements of the exception from the 

definition of a deferral of compensation 

if the taxpayer establishes that it was 

impracticable, either administratively or 

economically, to avoid the deferral of 

the receipt by a service provider of the 

payment beyond the applicable 21⁄2

month period and that, as of the time 

the legally binding right to the amount 

arose, such impracticability was 

unforeseeable, and the payment is made 

as soon as practicable. Some 

commentators had asked for a rule 

permitting delays due to unintentional 

error to satisfy the standard for the 

exclusion. However, the exception is 

based upon the longstanding position 

set forth in § 1.404(b)–1T, Q&A–2(b) 

regarding the timing of the deduction 

with respect to a payment under a 

nonqualified deferred compensation 

plan. Similar to the deduction rule, the 

exclusion from coverage under section 

409A treats a payment made within the 

appropriate 21⁄2 month period as made 

within such a short period following the 

date the substantial risk of forfeiture 

lapses that it may be treated as paid 

when earned (and not deferred to a 

subsequent period). Also similar to the 

rule governing the timing of deductions, 

the exclusion from coverage under 

section 409A permits only limited 

exceptions to the requirement that the 

amount actually be paid by the relevant 

deadline. Pending further study, the 

Treasury Department and the IRS 

believe that providing further flexibility 

with respect to meeting the deadline 

would create the potential for abuse and 

enforcement difficulty. 

C. Stock Options and Stock 

Appreciation Rights 

In General 

The legislative history states that 

section 409A does not cover grants of 

stock options where the exercise price 

can never be less than the fair market 

value of the underlying stock at the date 

of grant (a non-discounted option). See 

H.R. Conf. Rept. No. 108–755, at 735 

(2004). Thus an option with an exercise 

price that is or may be below the fair 

market value of the underlying stock at 

the date of grant (a discounted option) 

is subject to the requirements of section 

409A. Consistent with the legislative 

history and with Notice 2005–1, Q&A–

4, these regulations provide that a nondiscounted stock option, that has no 

other feature for the deferral of 

compensation, generally is not covered 

by section 409A. However, a stock 

option granted with an exercise price 

below the fair market value of the 

underlying shares of stock on the date 

of grant generally would be subject to 

section 409A except to the extent the 

terms of the option only permit exercise 

of the option during the short-term 

deferral period. 

Commentators stressed that in many 

respects, a stock appreciation right can 

be the economic equivalent of a stock 

option, especially a stock option that 

allows the holder to exercise in a 

manner other than by the payment of 

cash (a cashless exercise feature). 

Accordingly, Notice 2005–1, Q&A–4 

exempted from coverage certain nondiscounted stock appreciation rights 

that most closely resembled stock 

options—stock appreciation rights 

settled in stock. The Treasury 

Department and the IRS were concerned 

that the manipulation of the purported 

stock valuation for purposes of 

determining whether the stock 

appreciation right was issued at a 

discount or settled at a premium could 

lead to a stock appreciation right being 

used to circumvent section 409A. 

Accordingly, the exception was limited 

to stock appreciation rights issued with 

respect to stock traded on an established 

securities market. 

Commentators criticized the 

distinction between public corporations 

and non-public corporations, asserting 

that this distinction is not meaningful 

and unfairly discriminated against the 

latter corporations and placed such 

corporations at a severe competitive 

disadvantage. In addition, 

commentators questioned whether the 

distinction between stock-settled and 

cash-settled stock appreciation rights 

was relevant, where the amount of 

income generated would be identical. 

In response to the comments, these 

regulations treat stock appreciation 

rights similarly to stock options, 

regardless of whether the stock 

appreciation right is settled in cash and 

regardless of whether the stock 

appreciation right is based upon service 

recipient stock that is not readily 

tradable on an established securities 

market. The Treasury Department and 

the IRS remain concerned that 

manipulation of stock valuations, and 

manipulation of the characteristics of 

the underlying stock, may lead to abuses 

with respect to stock options and stock 

appreciation rights (collectively referred 

to as stock rights). To that end, these 

regulations contain more detailed 

provisions with respect to the 

identification of service recipient stock 

that may be subject to, or used to 

determine the amount payable under, 

stock rights excluded from the 

application of section 409A, and the 

valuation of such service recipient 

stock, discussed below. 

2. Definition of Service Recipient Stock 

The legislative history of section 409A 

states that the exception from coverage 

under section 409A for certain 

nonstatutory stock options was intended 

to cover options granted on service 

recipient stock. H.R. Conf. Rept. No. 

108–755, at 735 (2004). Section 

409A(d)(6) provides that, for purposes 

of determining the identity of the 

service recipient under section 409A, 

aggregation rules similar to the rules in 

section 414(b) and (c) apply. Taxpayers 

requested that the definition of service 

recipient be expanded for purposes of 

the exception for stock rights to cover 

entities that would not otherwise be 

treated as part of the service recipient 

applying the rules under section 414(b) 

and (c). The Treasury Department and 

the IRS agree that the exclusion for 

nonstatutory stock rights was not meant 

to apply so narrowly. Accordingly, for 

purposes of the provisions excluding 

certain stock rights on service recipient 

stock, the stock right, or the plan or 

arrangement under which the stock 

right is granted, may provide that 

section 414(b) and (c) be applied by 

modifying the language and using ‘‘50 

percent’’ instead of ‘‘80 percent’’ where 

appropriate, such that stock rights 

granted to employees of entities in 

which the issuing corporation owns a 50 

percent interest generally will not be 

subject to section 409A. 

Commentators also requested that the 

threshold be dropped below 50 percent 

to cover joint ventures and other similar 

arrangements, where the participating 

corporation does not have a majority 

interest. These regulations provide for 

such a lower threshold, allowing for the 

stock right, or the plan or arrangement 

under which the stock right is granted, 

to provide for the modification of the 

language and use of ‘‘20 percent’’

instead of ‘‘80 percent’’ in applying 

section 414(b) and (c), where the use of 

such stock with respect to stock rights 

is due to legitimate business criteria. For 

example, the use of such stock with 

57934 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

respect to stock rights issued to 

employees of a joint venture that were 

former employees of a corporation with 

at least a 20 percent interest in the joint 

venture generally would be due to 

legitimate business criteria, and 

accordingly would be treated as service 

recipient stock for purposes of 

determining whether the stock right was 

subject to section 409A. A designation 

by a service recipient to use either the 

50 percent or the 20 percent threshold 

must be applied consistently to all 

compensatory stock rights, and any 

designation of a different permissible 

ownership threshold percentage may 

not be made effective until 12 months 

after the adoption of such change. 

The increased ability to issue stock 

rights with respect to a related 

corporation for whom the service 

provider does not directly perform 

services could increase the potential for 

service recipients to exploit the 

exclusion for certain stock rights by 

establishing a corporation within the 

group of related corporations, the 

purpose of which is to serve as an 

investment vehicle for nonqualified 

deferred compensation. Accordingly, 

these regulations provide that other than 

with respect to service providers who 

are primarily engaged in providing 

services directly to such corporation, 

the term service recipient for purposes 

of the definition of service recipient 

stock does not include a corporation 

whose primary purpose is to serve as an 

investment vehicle with respect to the 

corporation’s interest in entities other 

than the service recipient (including 

entities aggregated with the corporation 

under the definition of service recipient 

incorporating section 414(b) and (c)). 

Commentators also questioned 

whether the exception for certain stock 

rights could apply where a service 

recipient provides a stock right with 

respect to preferred stock or a separate 

class of common stock. The Treasury 

Department and the IRS believe this 

exception was intended to cover stock 

rights with respect to service recipient 

stock the fair market value of which 

meaningfully relates to the potential 

future appreciation in the enterprise 

value of the corporation. The use of a 

separate class of common stock created 

for the purpose of compensating service 

providers, or the use of preferred stock 

with substantial characteristics of debt, 

could create an arrangement that more 

closely resembles traditional 

nonqualified deferred compensation 

arrangements rather than an interest in 

appreciation of the value of the service 

recipient. An exception that excluded 

these arrangements from coverage under 

section 409A would undermine the 

effectiveness of the statute to govern 

nonqualified deferred compensation 

arrangements, contrary to the legislative 

intent. Accordingly, these regulations 

clarify that service recipient stock 

includes only common stock, and only 

the class of common stock that as of the 

date of grant has the highest aggregate 

value of any class of common stock of 

the corporation outstanding, or a class 

of common stock substantially similar to 

such class of stock (ignoring differences 

in voting rights). In addition, service 

recipient stock does not include any 

stock that provides a preference as to 

dividends or liquidation rights. 

With respect to the foreign aspects of 

such arrangements, commentators 

requested clarification that service 

provider stock may include American 

Depositary Receipts (ADRs). These 

regulations clarify that stock of the 

service recipient may include ADRs, 

provided that the stock to which the 

ADRs relate would otherwise qualify as 

service recipient stock. 

Commentators also requested that 

certain equity appreciation rights issued 

by mutual companies, intended to 

mimic stock appreciation rights, be 

excluded from coverage under section 

409A. These regulations expand the 

exclusion for stock appreciation rights 

to include equity appreciation rights 

with respect to mutual company units. 

A mutual company unit is defined as a 

specified percentage of the fair market 

value of the mutual company. For this 

purpose, a mutual company may value 

itself under the same provisions 

applicable to the valuation of stock of a 

corporation that is not readily tradable 

on an established securities market. The 

Treasury Department and the IRS 

request comments as to the 

practicability of this provision, and 

whether such a provision should be 

expanded to cover equity appreciation 

rights issued by other entities that do 

not have outstanding shares of stock. 

3. Valuation 

Notice 2005–1, Q&A–4(d)(ii) provides 

that for purposes of determining 

whether the requirements for exclusion 

of a nonstatutory stock option have been 

met, any reasonable valuation method 

may be used. Commentators expressed 

concern that the standard was too 

vague, given the potential consequences 

of a failure to comply with the 

requirements of section 409A. 

These regulations provide that with 

respect to service recipient stock that is 

readily tradable on an established 

securities market, a valuation of such 

stock may be based on the last sale 

before or the first sale after the grant, or 

the closing price on the trading day 

before or the trading day of the grant, or 

any other reasonable basis using actual 

transactions in such stock as reported by 

such market and consistently applied. 

Commentators pointed out that certain 

service recipients, generally 

corporations in certain foreign 

jurisdictions, would not be able to meet 

this requirement because the service 

recipient is subject to foreign laws 

requiring pricing based on an average 

over a period of time. To allow 

compliance with these requirements, 

these regulations further provide that 

service recipients (including U.S. 

service recipients) may set the exercise 

price based on an average of the price 

of the stock over a specified period 

provided such period occurs within the 

30 days before and 30 days after the 

grant date, and provided further that the 

terms of the grant are irrevocably 

established before the beginning of the 

measurement period used to determine 

the exercise price. 

Commentators asked for clarification 

of the definition of stock that is readily 

tradable on an established securities 

market. Specifically, commentators 

requested clarification of the scope of an 

established securities market, and 

whether that term includes over-thecounter markets and foreign markets. 

The regulations adopt the definition of 

an established securities market set 

forth in § 1.897–1(m). Under that 

definition, over-the-counter markets 

generally are treated as established 

securities markets, as well as many 

foreign markets. However, the stock 

must also be readily tradable within 

such markets to qualify as stock readily 

tradable on an established securities 

market. 

With respect to corporations whose 

stock is not readily tradable on an 

established securities market, these 

regulations provide that fair market 

value may be determined through the 

reasonable application of a reasonable 

valuation method. The regulations 

contain a description of the factors that 

will be taken into account in 

determining whether a given valuation 

method is reasonable. In addition, in an 

effort to provide more certainty, certain 

presumptions with respect to the 

reasonableness of a valuation method 

have been set forth. Provided one such 

method is applied reasonably and used 

consistently, the valuation determined 

by applying such method will be 

presumed to equal the fair market value 

of the stock, and such presumption will 

be rebuttable only by a showing that the 

valuation is grossly unreasonable. A 

method will be treated as used 

consistently where the same method is 

used for all equity-based compensation 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57935 

granted to service providers by the 

service recipient, including for purposes 

of determining the amount due upon 

exercise or repurchase where the stock 

acquired is subject to an obligation of 

the service recipient to repurchase, or a 

put or call right providing for the 

potential repurchase by the service 

recipient, as applicable. 

Commentators specifically requested 

clarification as to whether a valuation 

method based upon an appraisal will be 

treated as reasonable, and if so with 

respect to what period. These 

regulations provide that the use of an 

appraisal will be presumed reasonable if 

the appraisal satisfies the requirements 

of the Code with respect to the valuation 

of stock held in an employee stock 

ownership plan. If those requirements 

are satisfied, the valuation will be 

presumed reasonable for a one-year 

period commencing on the date as of 

which the appraisal values the stock. 

Commentators also specifically 

requested clarification of whether a 

valuation method based on a nonlapse 

restriction addressed in § 1.83–5(a) will 

be treated as reasonable. Under § 1.83–

5(a), in the case of property subject to 

a nonlapse restriction (as defined in 

§ 1.83–3(h)), the price determined under 

the formula price is considered to be the 

fair market value of the property unless 

established to the contrary by the 

Commissioner, and the burden of proof 

is on the Commissioner with respect to 

such value. If stock in a corporation is 

subject to a nonlapse restriction that 

requires the transferee to sell such stock 

only at a formula price based on book 

value, a reasonable multiple of earnings 

or a reasonable combination thereof, the 

price so determined ordinarily is 

regarded as determinative of the fair 

market value of such property for 

purposes of section 83. 

The Treasury Department and the IRS 

do not believe that this standard, in and 

of itself, is appropriate with respect to 

the application of section 409A. The 

Treasury Department and the IRS are 

not confident that a formula price 

determined pursuant to a nonlapse 

restriction will, in every case, 

adequately approximate the value of the 

underlying stock. The Treasury 

Department and the IRS are also 

concerned that such formula valuations, 

in the absence of other criteria, may be 

subject to manipulation or to the 

provision of predictable results that are 

inconsistent with a true equity 

appreciation right. Further, the Treasury 

Department and the IRS do not believe 

that the burden of proof with respect to 

valuation should be shifted to the 

Commissioner in all cases where such 

formulas have been utilized. 

Accordingly, the use of a valuation 

method based on a nonlapse restriction 

that meets the requirements of § 1.83–

5(a) does not by itself result in a 

presumption of reasonableness. 

However, where the method is used 

consistently for both compensatory and 

noncompensatory purposes in all 

transactions in which the service 

recipient is either the purchaser or seller 

of such stock, such that the nonlapse 

restriction formula acts as a substitute 

for the value of the underlying stock, the 

formula will qualify for the presumption 

that the valuation method is reasonable 

for purposes of section 409A. In 

addition, depending on the facts and 

circumstances of the individual case, 

the use of a nonlapse restriction to 

determine value may be reasonable, 

taking into account other relevant 

valuation criteria. 

Commentators also expressed concern 

about the valuation of illiquid stock of 

certain start-up corporations. These 

commentators argued that the value of 

such stock is often highly speculative, 

rendering appraisals of limited value. 

Commentators also noted that such 

stock often is not subject to put rights 

or call rights that could be viewed as a 

nonlapse restriction. Given the 

illiquidity and speculative value, 

commentators argued that the risk that 

taxpayers would use rights on such 

shares as a device to pay deferred 

compensation is low. In response, these 

regulations propose additional 

conditions under which the valuation of 

illiquid stock in a start-up corporation 

will be presumed to be reasonable. A 

valuation of an illiquid stock of a startup corporation will be presumed 

reasonable if the valuation is made 

reasonably and in good faith and 

evidenced by a written report that takes 

into account the relevant factors 

prescribed for valuations generally 

under these regulations. For this 

purpose, illiquid stock of a start-up 

corporation refers to service recipient 

stock of a service recipient that is in the 

first 10 years of the active conduct of a 

trade or business and has no class of 

equity securities that are traded on an 

established securities market, where 

such stock is not subject to any put or 

call right or obligation of the service 

recipient or other person to purchase 

such stock (other than a right of first 

refusal upon an offer to purchase by a 

third party that is unrelated to the 

service recipient or service provider), 

provided that this rule does not apply 

to the valuation of any stock if the 

service recipient or service provider 

reasonably may anticipate, as of the 

time the valuation is applied, that the 

service recipient will undergo a change 

in control event or participate in a 

public offering of securities within the 

12 months following the event to which 

the valuation is applied (for example, 

the grant date of an award). A valuation 

will not be treated as made reasonably 

and in good faith unless the valuation 

is performed by a person or persons 

with significant knowledge and 

experience or training in performing 

similar valuations. 

As stated in the preamble to Notice 

2005–1, the Treasury Department and 

the IRS are concerned about the 

treatment of stock rights where the 

service recipient is obligated to 

repurchase the stock acquired pursuant 

to the stock right, or the service provider 

retains a put or call right with respect 

to the stock. Where the service provider 

retains such a right, the ability to 

receive a purchase price that differs 

from the fair market value of the stock 

could be used to circumvent the 

application of section 409A. 

Accordingly, these regulations generally 

require that where someone is obligated 

to purchase the stock received upon the 

exercise of a stock right, or the stock is 

subject to a put or call right, the 

purchase price must also be set at fair 

market value, the determination of 

which is also subject to the consistency 

requirements for the methods used in 

determining fair market value. 

4. Modification 

Commentators asked under what 

conditions a modification, extension, or 

renewal of a stock right will be treated 

as a new grant. The treatment as a new 

grant is relevant because although the 

original grant may have been excluded 

from coverage under section 409A, if the 

new grant has an exercise price that is 

less than the fair market value of the 

underlying stock on the date of the new 

grant, the new grant would not qualify 

for the exclusion from coverage under 

section 409A. Accordingly, the 

regulations set forth rules governing the 

types of modifications, extensions or 

renewals that will result in treatment as 

a new grant. The regulations provide 

that the term modification means any 

change in the terms of the stock right 

that may provide the holder of the right 

with a direct or indirect reduction in the 

exercise price of the stock right, or an 

additional deferral feature, or an 

extension or renewal of the stock right, 

regardless of whether the holder in fact 

benefits from the change in terms. 

Under this definition, neither the 

addition of a provision permitting the 

transfer of the stock right nor a 

provision permitting the service 

provider to exchange the stock right for 

57936 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

a cash amount equal to the amount that 

would be available if the stock right 

were exercised would be modifications 

of the stock right. In addition, these 

regulations explicitly provide that both 

a change in the terms of a stock right to 

allow for payment of the exercise price 

through the use of pre-owned stock, and 

a change in the terms of a stock right to 

facilitate the payment of employment 

taxes or required withholding taxes 

resulting from the exercise of the right, 

are not treated as modifications of the 

stock right for purposes of section 409A. 

Generally, a change to the exercise 

price of the stock right (other than in 

connection with certain assumptions or 

substitutions of a stock right in 

connection with a corporate transaction 

or certain adjustments resulting from a 

stock split, stock dividend or similar 

change in capitalization) is treated as a 

modification, resulting in a new grant 

that may be excluded from section 409A 

if it satisfies the requirements in these 

regulations as of the new grant date. 

However, depending upon the facts and 

circumstances, a series of repricings of 

the exercise price may indicate that the 

original right had a floating or 

adjustable exercise price and did not 

meet the requirements of the exclusion 

at the time of the original grant. 

Generally, an extension granting the 

holder an additional period within 

which to exercise the stock right beyond 

the time originally prescribed will be 

treated as evidencing an additional 

deferral feature meaning that the stock 

right was subject to section 409A from 

the date of grant. Commentators stated 

that it is not uncommon upon a 

termination of employment to extend 

the exercise period for some brief period 

of time to allow the terminated 

employee a chance to exercise the stock 

right. In response, these regulations 

provide that it is not an extension of a 

stock right if the exercise period is 

extended to a date no later than the later 

of the fifteenth day of the third month 

following the date, or December 31 of 

the calendar year in which, the right 

would otherwise have expired if the 

stock right had not been extended, 

based on the terms of the stock right at 

the original grant date. The regulations 

further provide that it is not an 

extension of a stock right if at the time 

the stock right would otherwise expire, 

the stock right is subject to a restriction 

prohibiting the exercise of the stock 

right because such exercise would 

violate applicable securities laws and 

the expiration date of the stock right is 

extended to a date no later than 30 days 

after the restrictions on exercise are no 

longer required to avoid a violation of 

applicable securities laws. 

These regulations also provide that if 

the requirements of § 1.424–1 (providing 

rules under which an eligible 

corporation may, by reason of a 

corporate transaction, substitute a new 

statutory option for an outstanding 

statutory option or assume an old option 

without such substitution or assumption 

being considered a modification of the 

old option) would be met if the right 

were a statutory option, the substitution 

of a new right pursuant to a corporate 

transaction for an outstanding right or 

the assumption of an outstanding right 

will not be treated as the grant of a new 

right or a change in the form of payment 

for purposes of section 409A. Section 

1.424–1 applies several requirements. 

Among them is the requirement under 

§ 1.424–1(a)(5)(ii) that the excess of the 

aggregate fair market value of the shares 

subject to the new option over the 

exercise price immediately after the 

substitution must not exceed the excess 

of the fair market value of the shares 

subject to the old option over the 

exercise price immediately before the 

substitution. In addition, § 1.424–

1(a)(5)(iii) requires that on a share by 

share comparison, the ratio of the 

exercise price to the fair market value of 

the shares subject to the option 

immediately after the substitution not 

be more favorable than the ratio of the 

exercise price to the fair market value of 

the shares subject to the old option 

immediately before the substitution. 

Commentators expressed concern that 

the use of the regulations contained in 

§ 1.424–1, and specifically the ratio test 

prescribed in § 1.424–1(a)(5)(iii), would 

prove difficult to apply in 

circumstances where, to reduce 

dilution, the acquiring corporation 

wished to issue a smaller number of 

shares than the shares underlying the 

old option, but also wished to retain the 

entire aggregate difference between the 

fair market value of the shares and the 

exercise price that had been available to 

the service provider before the 

substitution. In response, Notice 2005–

1, Q&A–4 and these regulations provide 

that the requirement of § 1.424–

1(a)(5)(iii) will be deemed to be satisfied 

if the ratio of the exercise price to the 

fair market value of the shares subject to 

the right immediately after the 

substitution or assumption is not greater 

than the ratio of the exercise price to the 

fair market value of the shares subject to 

the right immediately before the 

substitution or assumption. For 

example, if an employee had an option 

to purchase 25 shares for $2 per share, 

and immediately prior to a substitution 

by reason of a corporate transaction the 

fair market value of a share was $5, then 

the aggregate spread amount would be 

$75 (25 shares multiplied by ($5¥$2) = 

$75). The ratio of the exercise price to 

the fair market value would be $2/$5 = 

.40. As a part of the transaction, new 

employer wishes to substitute for the 

option an option to purchase 5 shares of 

new employer, when the shares have a 

fair market value of $20 per share. To 

maintain the aggregate spread of $75, 

the new grant has an exercise price of 

$5 (5 shares multiplied by ($20 ¥ $5) 

= $75). The ratio of the exercise price to 

the fair market value immediately after 

the substitution is $5/$20 = .25, which 

is not greater than the ratio immediately 

before the substitution. Provided that 

the other requirements of § 1.424–1 

were met, this substitution would not be 

considered a modification of the 

original stock option for purposes of 

section 409A. 

One commentator asked for more 

flexible rules concerning adjustments to 

and substitutions of options following a 

spinoff or similar transaction because 

short-term trading activity in the period 

immediately following such a 

transaction frequently does not 

accurately reflect the relative long-term 

fair market values of the stock of the 

distributing and distributed 

corporations. To address this problem, 

the regulations provide that such 

adjustments or substitutions may be 

made based on market quotations as of 

a predetermined date not more than 60 

days after the transaction, or based on 

an average of such market prices over a 

period of not more than 30 days ending 

not later than 60 days after the 

transaction. 

These provisions addressing 

substitutions and assumptions of rights 

apply to stock appreciation rights, as 

well as stock options. However, the 

guidance provided in these regulations 

with respect to the assumption of stock 

appreciation right liabilities should not 

be interpreted as guidance with respect 

to issues raised under any other 

provision of the Code or common law 

tax doctrine. 

D. Restricted Property 

Consistent with Notice 2005–1, Q&A–

4(e), these regulations provide that if a 

service provider receives property from, 

or pursuant to, a plan maintained by a 

service recipient, there is no deferral of 

compensation merely because the value 

of the property is not includible in 

income in the year of receipt by reason 

of the property being nontransferable 

and subject to a substantial risk of 

forfeiture, or is includible in income 

solely due to a valid election under 

section 83(b). However, a plan under 

which a service provider obtains a 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57937 

legally binding right to receive property 

(whether or not the property is 

restricted property) in a future year may 

provide for the deferral of compensation 

and, accordingly, may constitute a 

nonqualified deferred compensation 

plan. 

Commentators asked for clarification 

with respect to how this provision 

applies to a promise to transfer 

restricted property in a subsequent tax 

year. Specifically, commentators 

questioned how section 409A would 

apply to a bonus program offering a 

choice between a payment in cash and 

a payment in substantially nonvested 

property. Because the promise grants 

the service recipient a legally binding 

right to receive property in a future year, 

this promise generally could not 

constitute property for section 83 

purposes under § 1.83–3(e), and could 

constitute deferred compensation for 

purposes of section 409A. However, the 

regulations provide that the vesting of 

substantially nonvested property subject 

to section 83 may be treated as a 

payment for purposes section 409A, 

including for purposes of applying the 

short-term deferral rule. Accordingly, 

where the promise to transfer the 

substantially nonvested property and 

the right to retain the substantially 

nonvested property after the transfer are 

both subject to a substantial risk of 

forfeiture (as defined for purposes of 

section 409A), the arrangement 

generally would constitute a short-term 

deferral because the payment would 

occur simultaneously with the vesting 

of the right to the property. For 

example, where an employee 

participates in a two-year bonus 

program such that, if the employee 

continues in employment for two years, 

the employee is entitled to either the 

immediate payment of a $10,000 cash 

bonus or the grant of restricted stock 

with a $15,000 fair market value subject 

to a vesting requirement of three 

additional years of service, the 

arrangement generally would constitute 

a short-term deferral because under 

either alternative the payment would be 

received within the short-term deferral 

period. 

E. Arrangements Between Partnerships 

and Partners 

The statute and legislative history to 

section 409A do not specifically address 

arrangements between partnerships and 

partners providing services to a 

partnership, and do not explicitly 

exclude such arrangements from the 

application of section 409A. The 

application of section 409A to such 

arrangements raises a number of issues, 

relating both to the scope of the 

arrangements subject to section 409A, 

and the coordination of the provisions 

of subchapter K and section 409A with 

respect to those arrangements that are 

subject to section 409A. The Treasury 

Department and the IRS continue to 

analyze the issues raised in this area, 

and accordingly these regulations do not 

address arrangements between 

partnerships and partners. Notice 2005–

1, Q&A–7 provides interim guidance 

regarding the application of section 

409A to arrangements between 

partnerships and partners. Until further 

guidance is issued, taxpayers may 

continue to rely on Notice 2005–1, 

Q&A–7. 

Commentators have asked whether 

section 409A applies to guaranteed 

payments for services described in 

section 707(c). Until further guidance is 

issued, section 409A will apply to 

guaranteed payments described in 

section 707(c) (and rights to receive 

such guaranteed payments in the 

future), only in cases where the 

guaranteed payment is for services and 

the partner providing services does not 

include the payment in income by the 

15th day of the third month following 

the end of the taxable year of the partner 

in which the partner obtained a legally 

binding right to the guaranteed payment 

or, if later, the taxable year in which the 

right to the guaranteed payment is first 

no longer subject to a substantial risk of 

forfeiture. 

The Treasury Department and the IRS 

continue to request comments with 

respect to the application of section 

409A to arrangements between 

partnerships and partners. 

F. Foreign Arrangements 

The regulations provide guidance 

with respect to the application of 

section 409A to various foreign 

arrangements. As an initial matter, the 

regulations provide that an arrangement 

does not provide for a deferral of 

compensation subject to section 409A 

where the compensation subject to the 

arrangement would not have been 

includible in gross income for Federal 

tax purposes if it had been paid to the 

service provider at the time that the 

legally binding right to the 

compensation first arose or, if later, the 

first time that the legally binding right 

was no longer subject to a substantial 

risk of forfeiture, if the service provider 

was a nonresident alien at such time. 

Accordingly, if, for example, a foreign 

citizen works outside the United States 

and then retires to the United States, the 

compensation deferred and vested while 

working in the foreign country generally 

will not be subject to section 409A. 

With respect to U.S. citizens or 

resident aliens working abroad, the 

regulations provide that an arrangement 

does not provide for a deferral of 

compensation subject to section 409A 

where the compensation subject to the 

arrangement would have constituted 

foreign earned income (within the 

meaning of section 911) paid to a 

qualified individual (as defined in 

section 911(d)(1)) and the amount of the 

compensation is less than or equal to 

the difference between the maximum 

section 911 exclusion amount and the 

amount actually excludible from gross 

income under section 911 for the 

taxable year for the individual. This 

hypothetical exclusion is applied at the 

time that the legally binding right to the 

compensation first exists or, if later, the 

time that the legally binding right is no 

longer subject to a substantial risk of 

forfeiture. Under section 911, a U.S. 

citizen or resident alien who resides in 

a foreign jurisdiction generally may 

exclude up to $80,000 of foreign earned 

income (to be adjusted for inflation after 

2007). For example, an individual with 

$70,000 of foreign earned income 

excluded under section 911 in 2006 

could also defer up to $10,000 of 

additional compensation that would not 

be subject to section 409A, if the 

additional compensation would qualify 

as foreign earned income if paid to the 

individual in 2006. This exception to 

coverage under section 409A is 

intended to be applied on an annual 

basis, so that individuals will not be 

entitled to carry over any unused 

portion of the exclusion under section 

911 to a future year. This exception also 

is not intended to modify the rules 

under section 911 or the regulations 

thereunder. 

Similarly, these regulations also 

address deferrals of compensation 

income that would be excluded from 

gross income for Federal income tax 

purposes under section 893 (generally 

covering compensation paid to foreign 

workers of a foreign government or 

international organization working in 

the United States), section 872 

(generally covering certain 

compensation earned by nonresident 

alien individuals), section 931 

(generally covering certain 

compensation earned by bona fide 

residents of Guam, American Samoa, or 

the Northern Mariana Islands) and 

section 933 (generally covering certain 

compensation earned by bona fide 

residents of Puerto Rico). The 

regulations provide that an arrangement 

does not provide for a deferral of 

compensation subject to section 409A 

where the compensation subject to the 

57938 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

arrangement would have been excluded 

from gross income for Federal tax 

purposes under any of these sections, if 

the compensation had been paid to the 

service provider at the time that the 

legally binding right to the 

compensation first arose or, if later, the 

time that the legally binding right was 

no longer subject to a substantial risk of 

forfeiture. 

The Treasury Department and the IRS 

understand that nonresident aliens may 

work for very limited periods in the 

United States. Many deferrals of the 

compensation earned by nonresident 

aliens for services rendered in the 

United States will not be covered by 

section 409A, because under an 

applicable treaty the amount of 

compensation deferred would not be 

includible in gross income for Federal 

tax purposes if paid at the time the 

legally binding right to the 

compensation deferred was no longer 

subject to a substantial risk of forfeiture. 

However, certain compensation earned 

in the United States by a nonresident 

alien might be includible in gross 

income under such circumstances, 

where there is no applicable treaty or 

where the treaty does not provide an 

exclusion. Where a nonresident alien 

defers such compensation earned in the 

United States under a foreign 

nonqualified deferred compensation 

plan—for example because the service 

in the United States is credited under 

the plan—the application of section 

409A to the deferrals of the 

compensation subject to Federal income 

tax could be exceedingly burdensome in 

light of the relatively small amounts 

attributable to the service in the United 

States. Accordingly, these regulations 

adopt a de minimis exception, under 

which section 409A will not apply to an 

amount of compensation deferred under 

a foreign nonqualified deferred 

compensation plan for a given calendar 

year where the individual service 

provider is a nonresident alien for that 

calendar year and the amount deferred 

does not exceed $10,000. 

Commentators requested clarification 

of the application of section 409A to 

participation by U.S. citizens and 

resident aliens in foreign plans. In this 

context, it should be noted that under 

these regulations, transfers that are 

taxable under section 402(b) of the Code 

generally are not subject to section 

409A. See § 1.409A–1(b)(6) of these 

regulations and Notice 2005–1, Q&A–4. 

Such transfers may consist of 

contributions to an employees’ trust, 

where the trust does not qualify under 

section 501(a). Many foreign plans that 

hold contributions in a trust will 

constitute funded plans. To the extent 

that a contribution to the trust is subject 

to inclusion in income for Federal tax 

purposes under section 402(b), such a 

contribution will not be subject to 

section 409A. 

These regulations also provide that 

section 409A does not override treaty 

provisions that govern the U.S. Federal 

taxation of participation in particular 

foreign plans. Where a treaty provides 

that amounts contributed to a foreign 

plan by or on behalf of a service 

provider are not subject to U.S. Federal 

income tax, section 409A will not cause 

such amounts to be subject to inclusion 

in gross income. 

Some commentators requested that 

any participation in a foreign plan be 

exempted from section 409A, or that 

only deferrals of U.S. source 

compensation income be subject to 

section 409A. However, with respect to 

U.S. citizens working abroad, and with 

respect to resident aliens in the United 

States, compensation income generally 

is subject to U.S. Federal income tax 

absent an applicable treaty provision. 

Accordingly, the provisions of section 

409A generally are applicable to this 

type of deferred compensation. In 

addition, the Treasury Department and 

the IRS are concerned that providing a 

broad exception for foreign plans or 

foreign source income would create 

opportunities for U.S. citizens and 

resident aliens to avoid application of 

section 409A through participation in a 

foreign plan, or through reallocations of 

deferrals among U.S. source and foreign 

source income. 

The regulations provide, however, 

that with respect to non-U.S. citizens 

who are not lawful permanent residents 

of the United States, amounts deferred 

under certain broad-based foreign 

retirement plans are not subject to 

section 409A. This exception is 

intended to allow a worker who is not 

a green card holder to continue to 

participate in a broad-based foreign 

retirement plan that does not comply 

with section 409A without incurring 

adverse tax consequences due solely to 

the worker earning some income in the 

United States that is in some manner 

credited under the plan. 

Commentators expressed concerns as 

to U.S. citizens and lawful permanent 

residents working abroad, and their 

ability to participate in broad-based 

plans of foreign employers. Generally, 

these workers’ incomes are subject to 

Federal income tax, including section 

409A. However, when U.S. citizens and 

lawful permanent residents work abroad 

for employers who sponsor broad-based 

foreign retirement plans providing 

relatively low levels of retirement 

benefits and such plans are nonelective, 

the worker’s ability to control the timing 

of the income is limited. In such cases, 

the concerns with respect to the 

potential manipulation of the timing of 

compensation income addressed by 

section 409A are also limited, and do 

not outweigh the administrative 

burdens that would arise if a foreign 

employer’s failure to amend these plans 

to be consistent with the provisions of 

section 409A would result in substantial 

adverse tax consequences to U.S. 

citizens and lawful permanent residents 

working abroad who are covered by 

such plans. Accordingly, an exception 

for foreign broad-based retirement plans 

also applies with respect to U.S. citizens 

and lawful permanent residents, but 

only with respect to nonelective 

deferrals of foreign earned income and 

only to the extent that the amount 

deferred in a given year does not exceed 

the amount of contributions or benefits 

that may be provided by a qualified plan 

under section 415 (calculated by 

treating the foreign source income as 

compensation for purposes of section 

415). 

Commentators also requested that 

certain types of payments, referred to as 

expatriate allowances, be exempted 

from coverage under section 409A. 

These payments were defined broadly to 

include many types of payments to U.S. 

citizens working abroad, intended to put 

the service providers in substantially 

the same economic position as the 

service providers would have been in 

had the services been provided in the 

United States. One very common 

arrangement involves payments 

intended to compensate the service 

provider for any differences in tax rates, 

often referred to as tax equalization 

plans. With respect to these plans, the 

Treasury Department and the IRS 

recognize that such payments often 

must be delayed because of the need to 

calculate foreign tax liabilities after the 

end of the year. In addition, where the 

amounts are limited to the amounts 

necessary to make up for difference in 

tax rates, the potential for abuse with 

respect to the timing of compensation 

income is not great, since the 

compensation will directly relate to 

taxes that the service provider has paid 

to a foreign jurisdiction. Accordingly, 

these regulations exempt tax 

equalization plans from coverage under 

section 409A provided that the payment 

is made no later than the end of the 

second calendar year beginning after the 

calendar year in which the individual’s 

U.S. Federal income tax return is 

required to be filed (including 

extensions) for the year to which the tax 

equalization payment relates. 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57939 

Other payments are not excluded 

from section 409A merely because they 

are denominated as expatriate 

allowances. The Treasury Department 

and the IRS believe that the rules 

provided in these regulations with 

respect to setting and meeting payment 

dates under a nonqualified deferred 

compensation plan will provide 

sufficient flexibility to permit 

arrangements involving expatriate 

allowances to satisfy the requirements 

of section 409A. For example, as 

discussed more fully below, these 

regulations generally provide that to 

meet the requirement that a payment be 

made upon a permissible payment event 

or a fixed date, the service recipient may 

make the payment by the later of the 

earliest date administratively 

practicable following, or December 31 of 

the calendar year in which occurs, the 

permissible payment event or fixed 

date. At the minimum, this should offer 

almost 12 months of flexibility with 

respect to a payment scheduled for 

January 1 of a calendar year. The 

Treasury Department and the IRS 

request comments, however, as to 

circumstances in which this flexibility 

will not be sufficient. 

Commentators also requested a grace 

period during which arrangements with 

persons who have become resident 

aliens during a calendar year may be 

amended to comply with the 

requirements of section 409A. These 

regulations generally provide such 

relief. With respect to the initial year in 

which the service provider becomes a 

resident alien, the plan may be amended 

with respect to the service provider 

through the end of that year to comply 

with (or be excluded from coverage 

under) section 409A, including allowing 

the service provider the right to change 

the time and form of a payment. 

Provided that the election is made 

before the amount is paid or payable, 

initial deferral elections may also be 

made with respect to compensation 

related to services in that initial year, if 

the election is made by the end of the 

year or, if later, the 15th day of the third 

month after the service provider meets 

the requirements to be a resident alien. 

The relief generally does not extend 

further because a service recipient and 

service provider should reasonably 

anticipate the potential application of 

section 409A after the initial year in 

which the service provider attains the 

status of a resident alien. However, the 

Treasury Department and the IRS also 

recognize that there may be significant 

gaps between the years in which the 

service provider is treated as a resident 

alien. Accordingly, the grace period is 

available in a subsequent year, provided 

that the service provider has been a 

nonresident alien for at least five 

consecutive calendar years immediately 

preceding the year in which the service 

provider is again a resident alien. 

Commentators also requested that 

amounts contributed or benefits paid 

under a foreign social security system 

that is the subject of a totalization 

agreement be exempted from coverage 

under section 409A. Totalization 

agreements refer to bilateral agreements 

between the United States and foreign 

jurisdictions intended to coordinate 

coverage under the Social Security 

system in the United States and similar 

systems of the foreign jurisdictions. 

These agreements are intended to 

minimize the potential for application 

of two different employment taxes, and 

correspondingly to coordinate the 

benefits under the two different social 

security systems. The Treasury 

Department and the IRS believe that 

section 409A was not intended to apply 

to benefits to which the service provider 

is entitled under the foreign jurisdiction 

social security system. Accordingly, 

these types of plans have been excluded 

from the definition of a nonqualified 

deferred compensation plan for 

purposes of section 409A. Similarly, for 

jurisdictions not covered by a 

totalization agreement, these regulations 

provide that amounts deferred under a 

government mandated social security 

system are not subject to section 409A. 

G. Separation Pay Arrangements 

1. In General 

Many commentators requested 

clarification of the application of section 

409A to plans or arrangements 

providing payments upon a termination 

of services, generally described as 

severance plans. Some commentators 

requested that all such arrangements be 

excluded from coverage under section 

409A. However, section 409A(d)(1)(B) 

contains a list of welfare benefits that 

are specifically excluded from coverage 

under section 409A, including bona fide 

vacation leave, sick leave, compensatory 

time, disability pay and death benefit 

plans. Noticeably absent from this list is 

an exception for severance plans. This 

is particularly noteworthy because 

section 457(e)(11) contains the identical 

list of exclusions, with the one 

exception that the list of excluded plans 

under section 457(e)(11) includes 

severance pay plans, while the list of 

excluded plans under section 

409A(d)(1)(B) does not. Therefore, it 

appears that Congress intended that 

severance payments could constitute 

deferred compensation under section 

409A. To avoid confusion with other 

Code provisions, such as the specific 

exclusion from coverage under section 

457(e)(11) for severance plans or the 

treatment of such arrangements under 

section 3121(v)(2), these regulations 

generally refer to such arrangements as 

separation pay arrangements. 

With respect to payments available 

upon a voluntary termination of 

services, there is no substantive 

distinction between a plan labeled a 

severance plan or separation pay plan 

and a nonqualified deferred 

compensation plan that provides for 

payments upon a separation from 

service. If, as is often the case, the 

service recipient reserves the right to 

eliminate such arrangement at any time, 

the service provider may not have a 

legally binding right to the payment 

until payment actually occurs, or such 

other time as the service recipient’s 

discretion to eliminate the right to the 

payments lapses. However, as provided 

in these regulations, where such 

negative discretion lacks substantive 

significance, or the person granted the 

discretion is controlled by, or related to, 

the service provider to whom the 

payment will be made, the service 

provider will be considered to have a 

legally binding right to the 

compensation. 

Commentators requested that the 

exclusion from coverage under section 

409A contained in Notice 2005–1, 

Q&A–19(d) for payments during the 

calendar year 2005 to non-key 

employees pursuant to severance plans 

that are classified as welfare plans, 

rather than pension plans, in 

accordance with the Department of 

Labor regulations, be made a permanent 

exclusion. This approach generally 

would be consistent with the 

regulations under section 3121(v)(2) of 

the Code. However, the Department of 

Labor regulations reflect different 

concerns with respect to separation pay 

arrangements from the concerns 

addressed in section 409A. The 

Department of Labor regulations focus 

on whether an arrangement sufficiently 

resembles a retirement plan to require 

funding of the obligations under such a 

plan, or rather is a welfare plan that 

would not require funding. In contrast, 

section 409A focuses on the 

manipulation of the timing of inclusion 

of compensation income. Accordingly, 

these regulations do not categorically 

exclude these arrangements from 

coverage under section 409A, although 

a modified version of this exception has 

been provided, as discussed below. 

Some commentators requested that 

the Treasury Department and the IRS 

adopt an exclusion for all amounts 

57940 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

payable upon an involuntary separation. 

This request is based upon the position 

under certain other Code provisions, 

and stated in certain court cases, that 

payments to which an individual 

becomes entitled upon an involuntary 

separation from service do not 

constitute nonqualified deferred 

compensation. See Kraft Foods North 

America v. U.S., 58 Fed. Cl. 507 (2003); 

§ 31.3121(v)(2)–1(b)(4)(iv). As discussed 

above, the statutory language and 

structure of section 409A strongly 

suggest that separation pay 

arrangements, including arrangements 

providing separation pay upon an 

involuntary separation, were meant to 

be covered by section 409A. 

Furthermore, the Treasury Department 

and the IRS believe that section 409A 

was not intended to be applied so 

narrowly. Section 409A addresses the 

manipulation of the timing of inclusion 

of compensation. Payments due to a 

separation from service, regardless of 

whether voluntary or involuntary, 

constitute a payment of compensation. 

Accordingly, the ability to manipulate 

the timing of the inclusion of income 

related to the receipt of those amounts 

is within the scope of section 409A. 

Much of the discussion above relates 

to predetermined arrangements, where 

the right to the payment upon an 

involuntary termination of services 

arises as part of an arrangement 

covering multiple service providers, 

often covering a service provider from 

the time the service provider begins 

performing services. Where the 

separation pay arrangement involves an 

agreement negotiated with a specific 

service provider at the time of the 

involuntary separation from service, 

commentators asked how deferral 

elections could be provided that would 

meet the requirement that the election 

be made in the year before the year in 

which the services were performed. 

Commentators pointed out that even if 

the service provider does not already 

participate in any involuntary 

separation pay arrangement, the rule in 

section 409A(a)(4)(B) that allows an 

initial deferral election to be made 

within 30 days of initial eligibility 

under a plan applies only with respect 

to services performed after the election. 

To address these concerns, these 

regulations provide that where 

separation pay due to an involuntary 

termination has been the subject of bona 

fide, arm’s length negotiations, the 

election as to the time and form of 

payment may be made on or before the 

date the service provider obtains a 

legally binding right to the payment. 

The Treasury Department and the IRS 

recognize that separation pay 

arrangements providing for short-term 

payments upon an involuntary 

separation from service are common 

arrangements, and that compliance with 

the provisions of section 409A may be 

burdensome. In addition, the Treasury 

Department and the IRS recognize that 

where both the amount of the payments 

and the time over which such payments 

may be made are limited, these 

arrangements create fewer concerns 

with respect to manipulation of the 

timing of compensation income. 

Accordingly, these regulations generally 

exempt such arrangements where the 

entire amount of payments does not 

exceed two times the service provider’s 

annual compensation or, if less, two 

times the limit on annual compensation 

that may be taken into account for 

qualified plan purposes under section 

401(a)(17) ($210,000 for calendar year 

2005), each for the calendar year before 

the year in which the service provider 

separates from service, and provided 

further that the arrangement requires 

that all payments be made by no later 

than the end of the second calendar year 

following the year in which the service 

provider terminates service. These 

limitations generally are consistent with 

the safe harbor under which severance 

plans may be treated as welfare plans 

under the applicable Department of 

Labor regulations, and should allow 

most of these arrangements to avoid 

coverage under section 409A. 

The Treasury Department and the IRS 

further recognize that separation pay 

arrangements often occur in the context 

of a window program, where certain 

groups of service providers are 

identified as being subject to a 

separation from service, and the service 

recipient provides the identified service 

providers an incentive to voluntarily 

separate from service and obtain a 

benefit. Although technically these 

programs involve a voluntary separation 

from service, these regulations generally 

treat separations due to participation in 

a window arrangement the same as 

arrangements with respect to 

involuntary separations from service for 

purposes of the exceptions to coverage 

from section 409A. 

These exclusions for separation pay 

are not intended to allow for rights to 

payments that would otherwise be 

deferred compensation subject to 

section 409A to avoid application of 

section 409A by being recharacterized 

as separation pay. Accordingly, the 

exclusions for separation pay do not 

apply to the extent the separation pay 

acts as a substitute for, or a replacement 

of, amounts that would otherwise be 

subject to section 409A. For example, a 

right to separation pay obtained in 

exchange for the relinquishment of a 

right to a payment of deferred 

compensation subject to section 409A 

will not be excluded from coverage 

under section 409A, but rather will be 

treated as a payment of the original 

amount of deferred compensation. 

2. Treatment as a Separate Plan 

Commentators have stated that 

arrangements involving payments due 

to an involuntary separation often 

operate separately from more traditional 

types of nonqualified deferred 

compensation plans. In addition, 

especially in the case of agreements 

covering an individual, the involuntary 

separation pay agreement may involve 

many different types of payments that 

are of a much smaller magnitude than 

amounts deferred under other types of 

nonqualified deferred compensation 

plans. Commentators expressed 

concerns that inadvertent violations of 

section 409A with respect to these 

unique arrangements could lead to 

much larger amounts being included in 

income and subject to the additional tax 

under section 409A due to the 

aggregation of such involuntary 

separation pay arrangements with other 

arrangements under the definition of a 

plan. The Treasury Department and the 

IRS have concluded that a nonqualified 

deferred compensation plan providing 

separation pay due to an involuntary 

separation from service, or participation 

in a window program, should be treated 

as a separate type of plan from account 

balance plans, nonaccount balance 

plans, and other types of plans 

(generally equity-based compensation 

arrangements) in which the service 

provider may participate that do not 

provide separation pay due to an 

involuntary separation from service, or 

participation in a window program. 

3. Application of the Short-Term 

Deferral Rule to Separation Pay 

Arrangements 

Many commentators asked for a 

clarification with respect to the 

application of the short-term deferral 

rule to separation pay arrangements. 

The right to a payment that will only be 

paid upon an involuntary termination of 

services generally would be viewed as a 

nonvested right. Accordingly, an 

involuntary separation pay arrangement 

may be structured to meet the 

requirements of the short-term deferral 

exception. 

Some commentators also requested 

that arrangements involving rights to 

payments upon termination of services 

for good reason be treated as a right 

subject to a substantial risk of forfeiture. 

These arrangements are common, 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57941 

especially following a transaction 

resulting in a change in control of the 

service recipient. The Treasury 

Department and the IRS are not 

confident that amounts payable upon a 

voluntary separation from service, and 

amounts payable only upon a 

termination of services for good reason, 

always may be adequately 

distinguished. Furthermore, even if the 

types of good reasons sufficient to 

constitute a substantial risk of forfeiture 

could be elucidated, the application of 

such a rule would involve intensive 

factual determinations, leaving 

taxpayers uncertain in their planning 

and creating a significant potential for 

abuse. Accordingly, the regulations do 

not treat the right to a payment upon a 

separation from service for good reason 

categorically as a right subject to a 

substantial risk of forfeiture. However, 

the Treasury Department and the IRS 

request comments as to what further 

guidance may be useful with respect to 

arrangements containing these types of 

provisions. 

4. Reimbursement Arrangements 

Many commentators requested 

clarification with respect to the 

application of section 409A to 

reimbursement agreements, involving 

the service recipient reimbursing 

expenses of the terminated service 

provider. Because the promise to 

reimburse the former service provider is 

not contingent on the provision of any 

substantial services for the service 

provider, the right to the payment 

generally would not be treated as 

subject to a substantial risk of forfeiture. 

Accordingly, if the period in which 

expenses incurred will be reimbursed 

extends beyond the year in which the 

legally binding right arises, the right to 

the amount generally would constitute 

deferred compensation. The Treasury 

Department and the IRS recognize that 

reimbursement arrangements following 

a termination of services are common, 

and that requiring the service recipient 

to designate an amount at the time of 

the termination conflicts with the 

service recipient’s desire to pay only 

amounts that the former service 

provider has actually incurred as an 

expense. However, a categorical 

exclusion for reimbursement 

arrangements is not tenable, because 

such an exclusion would allow for a 

limitless amount of deferred 

compensation to be paid without regard 

to the rules of section 409A, where such 

compensation took the form of the 

reimbursement of personal expenses (for 

example, reimbursements of home 

mortgage payments). These regulations 

provide that certain reimbursement 

arrangements related to a termination of 

services are not covered by section 

409A, to the extent that the 

reimbursement arrangement covers only 

expenses incurred and reimbursed 

before the end of the second calendar 

year following the calendar year in 

which the termination occurs. The types 

of reimbursement arrangements 

excluded include reimbursements that 

are otherwise excludible from gross 

income, reimbursements for expenses 

that the service provider can deduct 

under section 162 or section 167, as 

business expenses incurred in 

connection with the performance of 

services (ignoring any applicable 

limitation based on adjusted gross 

income), outplacement expenses, 

moving expenses, medical expenses, as 

well as any other types of payments that 

do not exceed $5,000 in the aggregate 

during any given taxable year. 

For purposes of this provision, 

reimbursement arrangements include 

the provision of in-kind benefits, or 

direct payments by the service recipient 

to the person providing the goods or 

services to the terminated service 

provider, if the provision of such inkind benefits or direct payments would 

be treated as reimbursement 

arrangements if the service provider had 

paid for such in-kind benefits or such 

goods or services and received 

reimbursement from the service 

recipient. 

H. Split-Dollar Life Insurance 

Arrangements 

Commentators suggested that splitdollar life insurance arrangements 

should be excluded from the 

requirements of section 409A. However, 

the Treasury Department and the IRS 

believe that in applying the general 

definition of deferred compensation to 

split-dollar life insurance arrangements, 

the requirements of section 409A may 

apply to certain types of such 

arrangements (as described in § 1.61–

22). Split-dollar life insurance 

arrangements that provide only death 

benefits (as defined in these proposed 

regulations) to or for the benefit of the 

service provider may be excluded from 

coverage under section 409A under the 

exception from the definition of a 

nonqualified deferred compensation 

plan provided in these proposed 

regulations for death benefit plans. Also, 

split-dollar life insurance arrangements 

treated as loan arrangements under 

§ 1.7872–15 generally will not give rise 

to deferrals of compensation within the 

meaning of section 409A, provided that 

there is no agreement under which the 

service recipient will forgive the related 

indebtedness and no obligation on the 

part of the service recipient to continue 

to make premium payments without 

charging the service provider a market 

interest rate on the funds advanced. 

However, policies structured under the 

endorsement method, where the service 

recipient is the owner of the policy but 

where the service provider obtains a 

legally binding right to compensation 

includible in income in a taxable year 

after the year in which a substantial risk 

of forfeiture (if any) lapses, may provide 

for a deferral of compensation. Just as a 

promise to transfer property in a future 

year may provide for a deferral of 

compensation (even though the transfer 

itself is subject to section 83), an 

endorsement method split-dollar life 

insurance arrangement that grants the 

service provider a legally binding right 

to a future transfer of interests in a 

policy owned by the service recipient 

may provide for a deferral of 

compensation subject to section 409A. 

For example, where a service recipient 

enters into an endorsement method 

split-dollar life insurance arrangement 

with respect to a service provider, and 

irrevocably promises to pay premiums 

in future years, the arrangement may 

provide for a deferral of compensation 

within the meaning of section 409A. 

Commentators raised concerns about 

the impact of changes to a split-dollar 

life insurance arrangement to comply 

with section 409A, where the splitdollar life insurance arrangement was 

entered into on or before September 17, 

2003, and is not otherwise subject to the 

regulations set forth in § 1.61–22 (a 

grandfathered split-dollar life insurance 

arrangement). Pursuant to § 1.61–

22(j)(2), if a grandfathered split-dollar 

life insurance arrangement is materially 

modified after September 17, 2003, the 

arrangement is treated as a new 

arrangement entered into on the date of 

the modification. Commentators 

expressed concern that modifications 

necessary to comply with section 409A 

may cause the split-dollar life insurance 

arrangement to be treated as materially 

modified for purposes of § 1.61–22(j)(2). 

Comments are requested as to the scope 

of changes that may be necessary to 

comply with, or avoid application of, 

section 409A, and under what 

conditions those changes should not be 

treated as material modifications for 

purposes of § 1.61–22(j)(2). 

III. Definition of Plan 

A. Plan Aggregation Rules 

These regulations generally retain the 

plan aggregation rules set forth in Notice 

2005–1, Q&A–9. Under the notice, all 

amounts deferred under an account 

balance plan are treated as deferred 

57942 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

under a single plan, all amounts 

deferred under a nonaccount balance 

are treated as deferred under a single 

plan, and all amounts deferred under 

any other type of plan (generally equitybased compensation) are treated as 

deferred under a single plan. As 

discussed above, these regulations 

expand this rule so that all amounts 

deferred under certain separation pay 

arrangements are treated as a single 

plan. The purposes behind these 

aggregation rules are two-fold. First, 

because the provisions of section 409A 

are applied on an individual participant 

basis, rather than disqualifying the 

arrangement as to all participants, plan 

aggregation rules are necessary to 

implement the compliance incentives 

intended under the provision. Without 

such rules, multitudes of separate 

arrangements could be established for a 

single participant. Should the 

participant want access to an amount of 

cash, the participant would amend one 

or more of these separate arrangements 

and receive payments. The participant 

would argue that only those separate 

arrangements under which the amounts 

were paid failed to meet the 

requirements of section 409A and were 

subject to the income inclusion and 

additional tax, although in fact amounts 

were also available under the additional 

separate arrangements. Under that 

analysis, section 409A essentially would 

act as a 20 percent penalty required to 

receive a payment, similar to the haircut 

provisions that were intended to be 

prohibited by section 409A. The 

Treasury Department and the IRS do not 

believe that Congress intended that the 

consequences of section 409A could be 

limited in such a manner. However, the 

Treasury Department and the IRS also 

believe that complex plan aggregation 

rules, especially rules reliant on the 

particular facts and circumstances 

underlying each arrangement, would 

lead to unwarranted complexities and 

burdens with respect to service 

recipient planning and IRS enforcement. 

Accordingly, these regulations adopt 

rules intended to be simple and 

relatively easy to administer that retain 

the integrity of the compliance 

incentives inherent in the statute. 

Commentators asked whether an 

isolated violation of a term of an 

arrangement with respect to one 

participant will be treated as a violation 

of the same arrangement term with 

respect to other participants covered by 

the same arrangement. First, the terms 

of the arrangement with respect to each 

participant must be determined, based 

upon the rights the individual 

participant has under the plan. 

Generally, these rights will be 

determined based upon the written 

provisions applicable under a particular 

arrangement, as evidenced by a plan 

document, agreement, or some 

combination of documents that specify 

the terms of the contract under which 

the compensation is to be paid. 

However, where the terms of a plan or 

arrangement comply with section 409A, 

but the service recipient does not follow 

such terms, an individual participant’s 

actual rights under the arrangement may 

be unclear. Where a violation of a 

provision is not an isolated incident, or 

involves a number of participants or an 

identifiable subgroup of participants 

under the arrangement, the violation 

may result in a finding that even with 

respect to a participant who did not 

directly benefit from the violation, the 

actual terms of the arrangement differ 

from the written terms of the 

arrangement. For example, if a plan 

document provides for installment 

payments upon a separation from 

service, but participants in the 

arrangement repeatedly are offered the 

opportunity to receive a lump sum 

payment, the facts and circumstances 

may indicate that the arrangement 

provides for an election of a lump sum 

payment for all participants. 

An analogous analytical framework 

applies where the service recipient 

offers different benefits to separate 

participants in the same plan or 

arrangement. Under the terms of the 

overall arrangement, the service 

provider may grant many different types 

of rights, including some rights that 

would not be subject to the 

requirements of section 409A and some 

rights that would be subject to those 

requirements. With respect to the 

application of section 409A, a plan or 

arrangement is analyzed as consisting of 

the rights and benefits that have actually 

been granted to a particular service 

provider. For example, with respect to 

an equity-based omnibus plan that 

permits the grant of discounted stock 

options that would be subject to the 

requirements of section 409A, as well as 

other types of stock options which 

would be excluded from coverage under 

section 409A, only those service 

providers actually granted the 

discounted stock options will be treated 

as having deferred an amount of 

compensation subject to section 409A, 

and then only with respect to the stock 

options subject to section 409A. 

B. Written Plan Requirement 

Although the statute does not 

explicitly state that a plan or 

arrangement must be in writing, the 

statute requires that a plan contain 

certain provisions in order to comply 

with section 409A. For example, section 

409A(a)(2)(A) requires that a plan 

provide that compensation deferred 

under the plan may not be distributed 

earlier than certain specific events. 

Section 409A(a)(4)(B) requires that a 

plan provide certain restrictions with 

respect to initial deferral elections. 

Section 409A(a)(4)(C) requires that, if a 

plan permits under a subsequent 

election a delay in a payment or a 

change in the form of payment, the plan 

must require certain limits on the scope 

of such a delay or change. The clear 

implication of these provisions of 

section 409A is that the plan or 

arrangement must be set forth in writing 

and these regulations incorporate that 

requirement. 

IV. Definition of Substantial Risk of 

Forfeiture 

The scope of the definition of a 

substantial risk of forfeiture is central to 

the application of section 409A. In 

addition to the timing of the potential 

inclusion of income under section 

409A, the existence of a substantial risk 

of forfeiture may also determine 

whether an amount is subject to section 

409A or whether it qualifies for the 

exclusion under the short-term deferral 

rule. These regulations generally adopt 

the same definition as provided in 

Notice 2005–1, Q&A–10. This definition 

reflects the concerns of the Treasury 

Department and the IRS that the use of 

plan terms that purport to prescribe a 

substantial risk of forfeiture but, in fact, 

do not put the right to the payment at 

a substantial risk, may be used to 

circumvent the application of section 

409A in a manner inconsistent with the 

legislative intent. The definition of a 

substantial risk of forfeiture in these 

regulations contains certain restrictions. 

Certain amendments of an arrangement 

to extend a substantial risk of forfeiture 

will not be recognized. The ability to 

periodically extend, or roll, the risk of 

forfeiture is sufficiently suspect to 

question whether the parties ever 

intended that the right be subject to any 

true substantial risk, or rather whether 

the period is being extended through 

periods in which the service recipient 

can be reasonably assured that the 

forfeiture condition will not occur. 

Similarly, the risk that a right will be 

forfeited due to the violation of a 

noncompete agreement can be illusory, 

such as where the service provider has 

no intent to compete or to provide such 

services. In addition, a rational service 

provider normally would not agree to 

subject amounts that have already been 

earned, such as salary payments, to a 

condition that creates a real possibility 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57943 

of forfeiture, unless the service provider 

is offered a material inducement to do 

so, such as an additional amount of 

compensation. Accordingly, these 

provisions will not be treated as creating 

a substantial risk of forfeiture for 

purposes of section 409A. 

V. Initial Deferral Election Rules 

A. In General 

Section 409A(a)(4)(B)(i) provides that 

in general, a plan must provide that 

compensation for services performed 

during a taxable year may be deferred at 

the participant’s election only if the 

election to defer such compensation is 

made not later than the close of the 

preceding taxable year or at such other 

time as provided in regulations. The 

legislative history indicates that the 

taxable year to which the statute refers 

is the service provider’s taxable year, as 

it indicates that the Secretary may issue 

guidance ‘‘providing coordination rules, 

as appropriate, regarding the timing of 

elections in the case when the fiscal 

year of the employer and the taxable 

year of the individual are different.’’

H.R. Conf. Rep. No. 108–755, at 732 

(2004). Accordingly, these regulations 

provide as a general rule that a service 

provider must make a deferral election 

in his or her taxable year before the year 

in which the services are performed. As 

discussed below, certain coordination 

rules for fiscal year employers have 

been provided. 

An election to defer an amount 

includes an election both as to the time 

and form of the payment. An election is 

treated as made as of the date the 

election becomes irrevocable. Changes 

may be made to an initial deferral 

election, provided that the election 

becomes irrevocable (except to the 

extent the plan permits a subsequent 

deferral election consistent with these 

regulations) no later than the last date 

that such an election may be made. 

Commentators had questioned whether 

an evergreen deferral election, or a 

deferral election as to future 

compensation that remains in place 

unless the service provider changes the 

election, would be effective for purposes 

of section 409A. Such an election 

satisfies the initial deferral election 

requirements only if the election 

becomes irrevocable with respect to 

future compensation no later than the 

last permissible date an affirmative 

initial deferral election could have been 

made with respect to such 

compensation. For example, with 

respect to a salary deferral program 

under which an employee makes an 

initial deferral election to defer 10 

percent of the salary earned during the 

subsequent calendar year, a plan may 

provide that the deferral election 

remains effective unless and until 

changed by the employee, provided that 

with respect to salary earned during any 

future taxable year, the election to defer 

10 percent of such salary becomes 

irrevocable no later than the December 

31 of the preceding calendar year. 

B. Nonelective Arrangements 

Some commentators asked whether 

the initial deferral election rules apply 

to nonelective arrangements. The 

requirement that the election be made in 

the year before the services are 

performed is not applicable where the 

participant is not provided any election 

with respect to the amount deferred, or 

the time and form of the payment. 

However, as stated in the legislative 

history, ‘‘[t]he time and form of 

distribution must be specified at the 

time of initial deferral.’’ H.R. Conf. Rep. 

No. 108–755, at 732 (2004). In addition, 

the application of the subsequent 

deferral rules becomes problematic if 

the original time and form of deferred 

payment established by the service 

recipient is not viewed as an initial 

deferral election. Therefore, in order to 

avoid application of the initial deferral 

rules, a plan may not provide a service 

provider or service recipient with 

ongoing discretion as to the time and 

form of payment, but rather must set the 

time and form of payment no later than 

the time the service provider obtains a 

legally binding right to the 

compensation. 

C. Performance-Based Compensation 

Section 409A(a)(4)(B)(iii) provides 

that in the case of any performancebased compensation based on services 

performed over a period of at least 12 

months, a participant’s initial deferral 

election may be made no later than six 

months before the end of the period. 

The legislative history indicates that the 

performance-based compensation 

should be required to meet certain 

requirements similar to those under 

section 162(m), but not all requirements 

under that section. H.R. Conf. Rep. No. 

108–755, at 732 (2004). An example in 

the legislative history, adopted in these 

regulations, is that the requirement of a 

determination by the compensation 

committee of the board of directors is 

not required. 

Notice 2005–1 did not provide a 

definition of performance-based 

compensation. Rather, Notice 2005–1, 

Q&A–22 provided a definition of bonus 

compensation that, until further 

guidance was issued, could be used for 

purposes of applying the exception to 

the general rule regarding initial deferral 

elections. 

Under these regulations, performancebased compensation is defined as 

compensation the payment of which or 

the amount of which is contingent on 

the satisfaction of preestablished 

organizational or individual 

performance criteria. Performance-based 

compensation does not include any 

amount or portion of any amount that 

will be paid either regardless of 

performance, or based upon a level of 

performance that is substantially certain 

to be met at the time the criteria are 

established. 

Performance-based compensation 

generally may include payments based 

upon subjective performance criteria, 

provided that the subjective 

performance criteria relate to the 

performance of the participant service 

provider, a group of service providers 

that includes the participant service 

provider, or a business unit for which 

the participant service provider 

provides services (which may include 

the entire organization), and the 

determination that the subjective 

performance criteria have been met is 

not made by the service provider or a 

member of the service provider’s family, 

or a person the service provider 

supervises or over whose compensation 

the service provider has any control. 

Commentators requested that, similar 

to the provision contained in § 1.162–

27(e)(2) governing the requirements for 

establishing performance criteria for 

purposes of applying the deduction 

limitation under section 162(m), service 

recipients be allowed to establish 

performance criteria within 90 days of 

the commencement of a performance 

period of 12 months or more, rather 

than having to establish such criteria 

before the commencement of the period. 

These regulations adopt a similar 

provision with respect to the 

establishment of performance criteria 

for purposes of the exception under the 

deferral election rules, permitting the 

criteria to be established up to 90 days 

after the commencement of the period of 

service to which the criteria relates, 

provided that the outcome is not 

substantially certain at the time the 

criteria are established. 

The legislative history indicates that 

to constitute performance-based 

compensation, the amount must be (1) 

variable and contingent on the 

satisfaction of preestablished 

organizational or individual 

performance criteria and (2) not readily 

ascertainable at the time of the election. 

H.R. Conf. Rep. No. 108–755, at 732 

(2004). These regulations clarify that 

where the right to receive a specified 

57944 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

amount is itself not substantially 

certain, the amount is not readily 

ascertainable as the amount paid could 

either be the specified amount or zero. 

Accordingly, these regulations provide 

that at the time of the initial deferral 

election, either the amount must not be 

readily ascertainable, or the right to the 

amount must not be substantially 

certain. So, for example, the right to a 

$10,000 bonus that otherwise qualifies 

as performance-based compensation 

could be deferred by an employee up to 

six months before the end of the 

performance period, provided that at the 

time of the deferral election the 

employee is not substantially certain to 

meet the criteria and receive the $10,000 

payment. 

Under the definition of bonus 

compensation provided in Notice 2005–

1, Q&A–22, bonus compensation does 

not include any amount or portion of 

any amount that is based solely on the 

value of, or appreciation in value of, the 

service recipient or the stock of the 

service recipient. Commentators 

criticized this limitation as inconsistent 

with the provisions of § 1.162–27 

governing application of the deduction 

limitation under section 162(m), and the 

legislative history to section 409A 

indicating that the definition of 

performance-based compensation for 

purposes of section 409A would be 

similar to that provided under section 

162(m) and the regulations thereunder. 

These proposed regulations eliminate 

this limitation, so that performancebased compensation may be based 

solely upon an increase in the value of 

the service recipient, or the stock of the 

service recipient, after the date of grant 

or award. However, if an amount of 

compensation the service provider will 

receive pursuant to a grant or award is 

not based solely on an increase in the 

value of the stock after the grant or 

award (for example, in the case of 

restricted stock units or a stock right 

granted with an exercise price that is 

less than the fair market value of the 

stock as of the date of grant), and that 

other amount would not otherwise 

qualify as performance-based 

compensation, none of the 

compensation attributable to the grant 

or award is performance-based 

compensation. Nonetheless, an award of 

equity-based compensation may 

constitute performance-based 

compensation if entitlement to the 

compensation is subject to a condition 

that would cause a non-equity-based 

award to qualify as performance-based 

compensation, such as a performancebased vesting condition. 

The Treasury Department and the IRS 

are concerned that the inclusion of such 

amounts in the definition of 

performance-based compensation could 

lead to a conclusion that an election to 

defer amounts payable under a stock 

right will necessarily comply with 

section 409A if the initial deferral 

election is made at least 6 months before 

the date of exercise. However, under 

these proposed regulations, a stock right 

with a deferral feature is subject to 

section 409A from the date of grant. To 

comply with section 409A, the 

arrangement would be required to 

specify a permissible payment time and 

a form of payment. The requirement 

would not be met if, at some point 

during the term of the stock right, the 

stock right becomes immediately 

exercisable and the holder may decide 

whether and when to exercise the stock 

right. In addition, where a deferral 

feature is added to an existing stock 

right the stock right generally would 

violate section 409A because the stock 

right would have a deferral feature and 

would not have specified a permissible 

payment time or event. 

D. First Year of Eligibility 

Section 409A and these proposed 

regulations contain an exception to the 

general rule regarding initial deferral 

elections, under which a service 

provider newly eligible for participation 

in a plan may make a deferral election 

within the first 30 days of participation 

in the plan, provided that the election 

may only apply to compensation with 

respect to services performed after the 

election. These regulations further 

provide that for compensation that is 

earned based upon a specified 

performance period (for example, an 

annual bonus), where a deferral election 

is made in the first year of eligibility but 

after the beginning of the service period, 

the election is deemed to apply to 

compensation paid for service 

performed subsequent to the election if 

the election applies to the portion of the 

compensation that is no greater than the 

total amount of compensation for the 

performance period multiplied by the 

ratio of the number of days remaining in 

the performance period after the 

election over the total number of days 

in the performance period. 

Commentators had requested that the 

plan aggregation rules not apply in 

determining whether a service provider 

is newly eligible for participation in a 

plan. The concern is that a mid-year 

promotion, or management 

reorganization or other corporate event 

may make the service provider eligible 

for an arrangement that is of the same 

type as an arrangement in which the 

service provider already participates. 

For example, an employee participating 

in a salary deferral account-balance plan 

may become eligible for a bonus and a 

bonus deferral arrangement that would 

also be an account-balance plan. 

The Treasury Department and the IRS 

believe that the plan aggregation rules 

are necessary in this context. Without 

such a rule, service providers may 

attempt to take advantage of the new 

eligibility exception by establishing 

serial arrangements. For example, an 

employer may argue that a 2007 salary 

deferral program is a new program, and 

not a continuation of the 2006 salary 

deferral program. Commentators argue 

that standards should be provided 

comparing the terms of the two plans to 

distinguish new arrangements from 

those that are merely continuations of 

existing arrangements. However, such 

rules would by necessity be complicated 

and burdensome, generally relying on 

the facts and circumstances of the 

individual arrangements and resulting 

in administrative burden and 

uncertainties. Accordingly, these 

regulations retain the plan aggregation 

rules. 

However, as discussed below, certain 

other initial deferral election rules have 

been provided that address many of the 

situations in which service recipients 

desire to grant service providers the 

opportunity to make initial deferral 

elections due to eligibility in new 

programs. For example, the rule 

governing initial deferral elections with 

respect to certain forfeitable rights 

discussed below allows initial deferral 

elections upon eligibility for many 

bonus programs and ad hoc equitybased compensation grants. The 

Treasury Department and the IRS 

request comments as to whether these 

rules adequately address the concerns 

raised with respect to the definition of 

plan for purposes of applying the initial 

eligibility exception. 

E. Initial Deferral Election With Respect 

to Short-Term Deferrals 

As discussed above, an amount that is 

paid by the 15th day of the third month 

following the end of the first taxable 

year in which the payment is no longer 

subject to a substantial risk of forfeiture 

generally will not constitute a deferral 

of compensation. Commentators asked 

how the deferral election rules apply to 

an election to defer such an amount. 

Generally, once the service provider has 

begun performing the services required 

to vest, no election to defer could be 

made that would meet the timing 

requirements for initial deferral 

elections. Commentators suggested that 

the rules governing subsequent changes 

to the time and form of payment could 

be applied to elections to defer these 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57945 

amounts. The regulations provide that 

for purposes of an election to defer 

amounts that would not otherwise be 

subject to section 409A due to the shortterm deferral rule, the date the 

substantial risk of forfeiture lapses is 

treated as the original time of payment 

established by an initial deferral 

election, and the form in which the 

payment would be made absent a 

deferral election is treated as the 

original form of payment established by 

an initial deferral election. Accordingly, 

the service provider may elect to defer 

the payment beyond the time at which 

the payment originally was scheduled to 

be made, in accordance with the rules 

governing subsequent changes in the 

time and form of payment. In general, 

this means that the service provider 

must make the election at least 12 

months before the right to the payment 

vests, and must defer the payment for a 

period of not less than 5 years from the 

date the right to the payment could vest. 

Thus, no payment could be made within 

5 years of the date the right to the 

payment vests (including upon a 

separation from service), except for 

instances of a change in control of the 

corporation, death, disability or an 

unforeseeable emergency. This would 

also mean that if the right to the 

payment actually vests within 12 

months of the election, and the election 

is given effect so that the payment is not 

made within the short-term deferral 

period, the deferral of the payment 

would violate the requirements of 

section 409A. 

For example, an employee may be 

entitled to the immediate payment of a 

bonus upon the occurrence of an initial 

public offering, where such a condition 

qualifies as a substantial risk of 

forfeiture so that the arrangement would 

constitute a short-term deferral. At some 

point after obtaining the right to the 

payment but before the initial public 

offering, the employee elects to defer 

any potential bonus payment to a date 

5 years from the date of the initial 

public offering. To comply with the 

initial deferral election rules, that 

deferral election must not be given 

effect for 12 months. Accordingly, if the 

initial public offering occurred within 

12 months of the deferral election, the 

payment must be made at the time of 

the initial public offering in accordance 

with the short-term deferral rules. If the 

payment is not made at such time, but 

rather is made, for example, 5 years 

from the date of the initial public 

offering, the payment would be deemed 

deferred pursuant to an invalid initial 

deferral election effective before the 

required lapse of 12 months and the 

arrangement would violate section 

409A. 

F. Initial Deferral Election With Respect 

to Certain Forfeitable Rights 

Commentators asked how the initial 

deferral election rules would apply with 

respect to grants of nonqualified 

deferred compensation that occur in the 

middle of a taxable year, especially 

where such grants were unforeseeable 

by the service provider. Under these 

circumstances, an initial deferral 

election could not be made by the 

service provider during the taxable year 

before the year in which the award was 

granted, unless the service recipient had 

the foresight to request such an election 

in the prior year. The Treasury 

Department and the IRS do not believe 

that a categorical exclusion from the 

initial deferral election rules is 

appropriate, because such a rule would 

encourage the characterization of all 

grants of nonqualified deferred 

compensation as occurring in the 

middle of the year and in large part 

render ineffective the initial deferral 

election rules set forth in section 409A. 

However, these regulations provide that 

where a grant of nonqualified deferred 

compensation is subject to a forfeiture 

condition requiring the continued 

performance of services for a period of 

at least 12 months, the initial deferral 

election may be made no later than 30 

days after the date of grant, provided 

that the election is made at least 12 

months in advance of the end of the 

service period. Under these 

circumstances, the election still must be 

made in all cases at least 12 months 

before the service provider has fully 

earned the amount of compensation, 

analogous to the general requirement 

that the election be made no later than 

the end of the year before the services 

are performed. The Treasury 

Department and the IRS believe that 

such a rule will provide a reasonable 

accommodation to service recipients 

granting certain ad hoc awards, such as 

restricted stock units, that often are 

subject to a requirement that the service 

provider continue to perform services 

for at least 12 months. 

G. Initial Deferral Election With Respect 

to Fiscal Year Compensation 

The legislative history to section 409A 

indicates that the Treasury Department 

and the IRS are to provide guidance 

coordinating the initial deferral election 

rules with respect to compensation paid 

by service recipients with fiscal years 

other than the calendar year. H.R. Conf. 

Rep. No. 108–755, at 732 (2004). These 

regulations provide such a rule, 

generally permitting an initial election 

to defer fiscal year compensation on or 

before the end of the fiscal year 

immediately preceding the first fiscal 

year in which any services are 

performed for which the compensation 

is paid. For these purposes, fiscal year 

compensation does not encompass all 

compensation paid by a fiscal year 

service recipient. Where the 

compensation is not specifically based 

upon the service recipient’s fiscal year 

as the measurement period, the timing 

requirements applicable to an initial 

deferral election are unchanged. 

Accordingly, the rule applies to 

compensation based on service periods 

that are coextensive with one or more of 

the service recipient’s consecutive fiscal 

years, where no amount of such 

compensation is payable during the 

service period. For example, a bonus 

based upon a service period of two 

consecutive fiscal years payable after 

the completion of the second fiscal year 

would be fiscal year compensation. In 

contrast, periodic salary payments or 

bonuses based on service periods other 

than the service recipient’s fiscal year 

would not be fiscal year compensation, 

and the deferral of such amounts would 

be subject to the general rule. 

H. Deferral Elections With Respect to 

Commissions 

Commentators requested clarification 

with respect to the application of 

section 409A to commissions. These 

regulations address commissions earned 

by a service provider where a 

substantial portion of the services 

provided by the service provider 

consists of the direct sale of a product 

or service to a customer, each payment 

of compensation by the service recipient 

to the service provider consists of a 

portion of the purchase price for the 

product or service (for example, 10 

percent of the purchase price), or an 

amount calculated solely by reference to 

the volume of sales (for example, $100 

per item sold), and each compensation 

payment is contingent upon the service 

recipient receiving payment from an 

unrelated customer for the product or 

services. In that case, the service 

provider is treated as having performed 

the services to which the commission 

compensation relates during the service 

provider’s taxable year in which the 

unrelated customer renders payment for 

such goods or services. Accordingly, 

under the general initial deferral 

election rule an individual service 

provider could make an initial deferral 

election with respect to such 

compensation through December 31 of 

the calendar year preceding the year in 

which the customer renders the 

57946 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

payment from which the commission is 

derived. 

VI. Time and Form of Payment 

A. In General 

The regulations incorporate the 

statutory requirement that payments be 

made at a fixed date or under a fixed 

schedule, or upon any of five events: a 

separation from service, death, 

disability, change in the ownership or 

effective control of a corporation (to the 

extent provided by the Secretary), or 

unforeseeable emergency. As requested 

by commentators, these regulations 

provide guidance on what it means for 

a payment to be made upon one of these 

events. Where the time of payment is 

based upon the occurrence of a 

specified event (such as one of the five 

events listed above or upon the lapse of 

a substantial risk of forfeiture as 

discussed below), the plan must 

designate an objectively determinable 

date or year following the event upon 

which the payment is to be made. For 

example, the plan may designate the 

payment date as 30 days following a 

separation from service, or the first 

calendar year following a service 

provider’s death. The Treasury 

Department and the IRS recognize that 

it may not be administratively feasible 

to make a payment upon the exact date 

or year designated. Furthermore, the 

Treasury Department and the IRS 

recognize that certain minimal delays 

that do not meaningfully affect the 

timing of the inclusion of income 

should not result in a violation of the 

requirements of section 409A. 

Accordingly, a payment will be treated 

as made upon the designated date if the 

payment is made by the later of the first 

date it is administratively feasible to 

make such payment on or after the 

designated date, or the end of the 

calendar year containing the designated 

date (or the end of the calendar year if 

only a year is designated). This 

relaxation of the timing rules for 

administrative necessity is not intended 

to provide a method for the service 

provider to further defer the payment. 

Accordingly, any inability to make the 

payment that is caused by an action or 

inaction of the service provider, or any 

person related to, or under the control 

of, the service provider, will not be 

treated as causing the making of the 

payment to be administratively 

infeasible. 

Once an event upon which a payment 

is to be made has occurred, the 

designated date generally is treated as 

the fixed date on which, or the fixed 

schedule under which, the payment is 

to be made (but not for purposes of the 

application of section 409A(a)(2)(B) 

generally requiring a six month delay in 

any payment upon a separation from 

service to a key employee of a 

corporation whose stock is traded on an 

established securities market). 

Accordingly, the recipient may change 

the time and form of payment after the 

event has occurred, provided that the 

change would otherwise be timely and 

permissible under these regulations. For 

example, a plan provides for payment of 

a lump sum on the third anniversary 

following a separation from service. A 

service provider has a separation from 

service on July 1, 2010. The July 1, 

2013, payment date is now treated as 

the fixed date upon which the payment 

is to be made. Accordingly, the service 

provider generally could elect to defer 

the time and form of payment provided 

that the election were made on or before 

June 30, 2012, and deferred the payment 

to at least July 1, 2018. For a discussion 

of the application of the subsequent 

deferral rules when only a calendar year 

of payment is specified, see section VI.B 

of this preamble. 

B. Specified Time or Fixed Schedule of 

Payments 

Generally a plan will be deemed to 

provide for a specified time or fixed 

schedule of payments where, at the time 

of the deferral, the specific date upon 

which the payment or payments will be 

made may be objectively determined. As 

requested by commentators, these 

regulations permit plans to specify 

simply the calendar year or years in 

which the payments are scheduled to be 

made, without specifying the particular 

date within such year on which the 

payment will be made. Although this 

provision would be consistent with the 

flexibility allowed with respect to 

meeting the specified time or fixed 

schedule of payments requirement, the 

provision must be coordinated with the 

subsequent deferral rules. Section 

409A(a)(4)(C)(iii) requires that if a plan 

permits under a subsequent election a 

delay in a payment or a change in the 

form of payment with respect to a 

payment payable at a specified time or 

a fixed schedule, the plan must require 

that the election be made not less than 

12 months prior to the date of the first 

scheduled payment. Application of such 

a provision requires a specific date for 

the first scheduled payment. For a plan 

that does not designate a specific date, 

but rather only the year in which the 

payment is to be made, the first 

scheduled payment is deemed to be 

scheduled to be paid as of January 1 of 

such year for this purpose. 

Commentators asked whether a 

specified time or fixed schedule of 

payments could be determined based 

upon the date the service provider vests 

in the amount of deferred 

compensation, where the vesting is 

based upon the occurrence of an event. 

These regulations provide that a plan 

provides for payment at a specified time 

or fixed schedule of payments if the 

plan provides at the time of the deferral 

that the payment will be made at a date 

or dates that are objectively 

determinable based upon the date of the 

lapsing of a substantial risk of forfeiture, 

disregarding any acceleration of the 

vesting other than due to death or 

disability. So, for example, a plan that 

provides at the time the service provider 

obtains a legally binding right to the 

payment that the payment will be made 

in three installment payments, payable 

each December 31 following an initial 

public offering, where the condition that 

an initial public offering occur before 

the service provider is entitled to a 

payment constitutes a substantial risk of 

forfeiture, would satisfy the requirement 

that the plan provide for payments at a 

specified time or pursuant to a fixed 

schedule. 

C. Separation From Service 

Section 409A(a)(2)(A)(i) provides that 

a plan may permit a payment to be 

made upon a separation from service as 

determined by the Secretary (except a 

payment to a specified employee, in 

which case the payment must be made 

subject to a six-month delay, discussed 

more fully below). These regulations 

provide guidance as to the 

circumstances under which service 

providers, including employees and 

independent contractors, will be treated 

as separating from service for purposes 

of section 409A. These rules are 

intended solely as guidance with 

respect to section 409A(a)(2)(A)(i), and 

should not be relied upon with respect 

to any other Code provisions, such as 

provisions with respect to distributions 

under qualified plans and provisions 

related to the service recipients’

employment tax and information 

reporting obligations. 

1. Employees 

These regulations provide that an 

employee experiences a separation from 

service if the employee dies, retires, or 

otherwise has a termination of 

employment with the employer. 

However, the employment relationship 

is treated as continuing intact while the 

individual is on military leave, sick 

leave, or other bona fide leave of 

absence (such as temporary employment 

by the Government) if the period of such 

leave does not exceed six months, or if 

longer, so long as the individual’s right 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57947 

to reemployment with the service 

recipient is provided either by statute or 

by contract. If the period of leave 

exceeds six months and the individual’s 

right to reemployment is not provided 

either by statute or by contract, the 

employment relationship is deemed to 

terminate on the first date immediately 

following such six-month period. 

Whether the employee has 

experienced a termination of 

employment is determined based on the 

facts and circumstances. The Treasury 

Department and the IRS do not intend 

for this standard to allow for the 

extension of deferrals through the use of 

consulting agreements or other devices 

under which the service provider 

technically agrees to perform services as 

demanded, but for which there is no 

intent that the service provider perform 

any significant services. Accordingly, 

the regulations provide an anti-abuse 

rule stating that where an employee 

either actually or purportedly continues 

in the capacity as an employee, such as 

through the execution of an 

employment agreement under which the 

service provider agrees to be available to 

perform services if requested, but the 

facts and circumstances indicate that 

the employer and the service provider 

did not intend for the service provider 

to provide more than insignificant 

services for the employer, an employee 

will be treated as having a termination 

of employment and a separation from 

service. For these purposes, an 

employer and employee will be deemed 

to have intended for the employee to 

provide more than insignificant services 

if the employee provides services at an 

annual rate equal to at least 20 percent 

of the services rendered and the annual 

remuneration for such services is equal 

to at least 20 percent of the average 

remuneration earned during the 

immediately preceding three full 

calendar years of employment (or, if the 

employee was employed for less than 

three years, such lesser period). 

In addition, the Treasury Department 

and the IRS do not intend for this 

standard to be circumvented to create a 

separation from service where the 

service provider continues to perform 

significant services for the service 

recipient. For these purposes, the 

regulations provide that where an 

employee continues to provide services 

to a previous employer in a capacity 

other than as an employee, a separation 

from service will be treated as not 

having occurred if the former employee 

provides services at an annual rate that 

is 50 percent or more of the services 

rendered, on average, during the final 

three full calendar years of employment 

(or, if less, such lesser period) and the 

annual remuneration for such services is 

50 percent or more of the average 

annual remuneration earned during the 

immediately preceding three full 

calendar years of employment (or if less, 

such lesser period). 

Commentators asked whether the 

previous positions of the Treasury 

Department and the IRS with respect to 

a separation from service for purposes of 

section 401(k), generally referred to as 

the same desk rule, would apply in 

these circumstances. Under that rule, in 

certain situations where the identity of 

the employee’s employer changed, such 

as with respect to a sale of substantially 

all of the assets of the original employer 

to a new employer who hired the 

employee, the employee would not be 

treated as having a separation from 

service where the duties and 

responsibilities of the employee had not 

materially changed. These regulations 

do not incorporate this standard. 

Commentators had requested the 

ability to elect whether to apply the 

same desk rule in the case of a corporate 

transaction, such as a sale of 

substantially all of the assets of the 

original employer. The Treasury 

Department and the IRS do not believe 

that such a rule would be consistent 

with the provisions of section 409A, 

which generally restrict such control 

over the time and form of payment. 

2. Independent Contractors 

The definition of a separation from 

service of an independent contractor in 

these proposed regulations generally is 

derived from the definition of severance 

from employment provided in § 1.457–

6(b)(2). Comments are requested with 

respect to any changes that may be 

necessary to address issues arising 

under section 409A. 

3. Delay for Key Employees 

Section 409A(a)(2)(B)(i) provides that 

payments upon a separation from 

service to a key employee of a 

corporation whose stock is publicly 

traded on an established securities 

market must be delayed at least six 

months following the separation from 

service. For these purposes, a key 

employee is defined in accordance with 

section 416(i), disregarding section 

416(i)(5). Commentators asked for 

guidance on when a determination as to 

whether an individual is a key 

employee must be made. Section 416 

relies upon plan year concepts, which 

generally are not relevant to the 

application of section 409A. In addition, 

the Treasury Department and the IRS 

wish to establish rules that minimize 

the administrative burden, while 

implementing the legislative intent. 

Accordingly, the regulations provide 

that the identification of key employees 

is based upon the 12-month period 

ending on an identification date chosen 

by the service recipient. Persons who 

meet the requirements of section 

416(i)(1)(A)(i), (ii) or (iii) during that 12- 

month period are considered key 

employees for the 12-month period 

commencing on the first day of the 4th 

month following the end of the 12- 

month period. For example, if an 

employer chose December 31 as an 

identification date, any key employees 

identified during the calendar year 

ending December 31 would be treated as 

specified employees for the 12-month 

period commencing the following April 

1. In this manner, service recipients 

generally may know in advance whether 

the person to whom a payment is 

scheduled to be made will be subject to 

the provision. In addition, service 

recipients may choose an identification 

date other than December 31, provided 

that the date must be used consistently 

and provided that any change in the 

identification date may not be effective 

for a period of at least 12 months. 

Some commentators had requested 

that certain types of payments, generally 

life annuities or longer-term installment 

payments, be excepted from the sixmonth delay requirement. The statutory 

language does not contemplate such an 

exception. Where an executive is aware 

that the source of funds to pay for his 

nonqualified deferred compensation are 

at significant risk, the executive may 

separate from service to obtain initial 

annuity or installment payments while 

such funds exist. Commentators argue 

that annuity payments or long-term 

installment payments generally would 

be less significant in amount. However, 

the Treasury Department and the IRS 

are not inclined to establish arbitrary 

limits, where such amounts may 

actually be quite significant due to the 

overall amount of the entire benefit, the 

number of installment payments, or the 

age of the participant, especially where 

the statutory language does not 

contemplate the creation of such an 

exception. Rather, the Treasury 

Department and the IRS believe that the 

provisions with respect to separation 

pay should provide service recipients 

the ability to provide reasonably 

significant amounts of benefits to 

terminating executives, that may 

respond to many of the concerns 

underlying the request to relax the sixmonth delay requirement. 

To meet the six-month delay 

requirement, a plan may provide that 

any payment pursuant to a separation of 

service due within the six-month period 

is delayed until the end of the sixVerDate Aug<31>2005 17:20 Oct 03, 2005 Jkt 205001 PO 00000 Frm 00019 Fmt 4701 Sfmt 4702 E:\FR\FM\04OCP2.SGM 04OCP2
57948 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

month period, or that each scheduled 

payment that becomes payable pursuant 

to a separation from service is delayed 

six months, or a combination thereof. 

For example, a nonqualified deferred 

compensation plan of a corporation 

whose stock is publicly traded on an 

established securities market may 

provide that a participant is entitled to 

60 monthly installment payments upon 

separation from service, payable 

commencing the first day of the first 

month following the date of separation 

from service. To comply with the 

requirement of a six-month delay for 

payments to key employees, the plan 

may provide that in the case of an 

affected participant, the aggregate 

amount of the first seven months of 

installments is paid at the beginning of 

the seventh month following the date of 

separation from service, or may provide 

that the commencement date of the 60 

months of installment payments is the 

first day of the seventh month following 

the date of separation from service, or 

may provide for a combination of these 

provisions. A plan may be amended to 

specify or change the manner in which 

the delay will be implemented, 

provided that the amendment may not 

be effective for at least 12 months. 

Because the delay requirement applies 

only to certain public corporations, a 

corporation or other entity not covered 

by the requirement may have failed to 

include a provision in its plans at the 

time the corporation is contemplating 

becoming a public corporation. These 

regulations provide that where the stock 

of the service recipient is not publicly 

traded on an established securities 

market, a plan may be amended to 

specify or change the manner in which 

the delay will be implemented, effective 

immediately upon adoption of the 

amendment. A plan may provide a 

service provider an election as to the 

manner in which the six-month delay is 

to be implemented, provided that such 

election is subject to otherwise 

applicable deferral election rules. 

D. Death or Disability 

As provided in section 

409A(a)(2)(A)(ii) and (iii), these 

regulations state that the death or 

disability of the service provider are 

permissible payment events. The 

regulations incorporate the definition of 

disability provided in section 

409A(a)(2)(C). These regulations clarify 

that a plan that provides for a payment 

upon a disability need not provide for 

a payment upon all disabilities 

identified in section 409A(a)(2)(C), as 

long as any disability upon which a 

payment would be made is contained 

within the definition provided in 

section 409A(a)(2)(C). In addition, these 

regulations provide that a service 

recipient may rely upon a determination 

of the Social Security Administration 

with respect to the existence of a 

disability. 

E. Change in Ownership or Effective 

Control of the Corporation 

The provisions defining a change in 

ownership or effective control of a 

corporation remain substantially 

unchanged from Notice 2005–1, Q&As–

11 through 14. These provisions are 

based largely upon the discussion in the 

legislative history, indicating that the 

guidance should provide a similar, but 

more restrictive, definition of a change 

in the ownership or effective control of 

a corporation as compared to the 

definition used for purposes of the 

golden parachute provisions of section 

280G. H.R. Conf. Rep. No. 108–755, at 

730 (2004). Accordingly, the provisions 

largely mirror the regulations under 

section 280G, though the percentage 

changes in ownership necessary to 

qualify as permissible payment events 

have increased. However, unlike the 

golden parachute provisions, a change 

in control event may occur that does not 

relate to the entire group of affiliated 

corporations. Rather, the relevant 

analysis for purposes of section 409A 

generally is whether the corporation for 

whom the service provider performed 

services at the time of the event, the 

corporation or corporations liable for 

the payment at the time of the event, or 

a corporate majority shareholder of one 

of these corporations, experienced a 

change in control event. 

Commentators asked whether the 

provisions relating to the change in 

ownership or effective control of a 

corporation will be extended to noncorporate entities. Specifically, some 

commentators asked whether change in 

control provisions could be applied in 

the case of a partnership or other passthrough entity. Neither the statute nor 

the legislative history refers to a 

permissible distribution upon a change 

in ownership or effective control of any 

type of entity other than a corporation. 

However, the Treasury Department 

and the IRS plan to issue regulations 

under section 409A(a)(3) that will allow 

an acceleration of payments upon a 

change in the ownership of a 

partnership or in the ownership of a 

substantial portion of the assets of the 

partnership. Until further guidance is 

issued, the section 409A rules regarding 

permissible distributions upon a change 

in the ownership of a corporation (as 

described in proposed § 1.409A–

3(g)(5)(iv)) or a change in the ownership 

of a substantial portion of the assets of 

a corporation (as described in proposed 

§ 1.409A–3(g)(5)(vi)) may be applied by 

analogy to changes in the ownership of 

a partnership and changes in the 

ownership of a substantial portion of the 

assets of a partnership. For purposes of 

this paragraph, any references in 

proposed § 1.409A–3(g)(5) to 

corporations, shareholders, and stock 

shall be treated as referring also to 

partnerships, partners, and partnership 

interests, respectively, and any 

reference to ‘‘majority shareholder’’ as 

applied by analogy to the owner of a 

partnership shall be treated as referring 

to a partner that (a) owns more than 50 

percent of the capital and profits 

interests of such partnership, and (b) 

alone or together with others is vested 

with the continuing exclusive authority 

to make the management decisions 

necessary to conduct the business for 

which the partnership was formed. The 

Treasury Department and the IRS 

request comments with respect to the 

application of a change in control 

provision to partnerships and other noncorporate entities, as well as suggestions 

with respect to the formulation of which 

types of events should qualify and 

would be analogous to the corporate 

events described in the regulations. 

Commentators also raised questions 

regarding the application of section 

409A to earn-out provisions where an 

acquirer contracts to make an immediate 

payment at the closing of the transaction 

with additional amounts payable at a 

later date, subject to the satisfaction of 

specified conditions. In such situations, 

the later payments could create delays 

in payments of compensation calculated 

by reference to the value of target 

corporation shares. These regulations 

address this situation by providing that 

compensation payable pursuant to the 

purchase by the service recipient of 

service recipient stock or a stock right 

held by a service provider, or payment 

of amounts of deferred compensation 

calculated by reference to the value of 

service recipient stock, may be treated 

as paid at a specified time or pursuant 

to a fixed schedule in conformity with 

the requirements of section 409A if paid 

on the same schedule and under the 

same terms and conditions as payments 

to shareholders generally pursuant to a 

change in the ownership of a 

corporation that qualifies as a change in 

control event or as payments to the 

service recipient pursuant to a change in 

the ownership of a substantial portion of 

a corporation’s assets that qualifies as a 

change in control event, and any 

amounts paid pursuant to such a 

schedule and such terms and conditions 

will not be treated as violating the 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57949 

initial or subsequent deferral election 

rules, to the extent that such amounts 

are paid not later than five years after 

the change in control event. 

F. Unforeseeable Emergency 

The regulations contain provisions 

defining the types of circumstances that 

constitute an unforeseeable emergency, 

and the amounts that may be paid due 

to the unforeseeable emergency. 

Generally these provisions are derived 

directly from section 409A(a)(2)(B)(ii). 

Commentators requested that in the case 

of an unforeseeable emergency, a service 

provider be permitted to cancel future 

deferrals. This issue is discussed in this 

preamble at paragraph VII.D. 

G. Multiple Payment Events 

The regulations permit a plan to 

provide that payments may be made 

upon the earlier of, or the later of, two 

or more specified permissible payment 

events or times. In addition, the 

regulations provide that a different form 

of payment may be elected for each 

potential payment event. For example, a 

plan may provide that a service provider 

will receive an installment payment 

upon separation from service or, if 

earlier, a lump sum payment upon 

death. The application of the rules 

governing changes in time and form of 

payment and the anti-acceleration rules 

to amounts subject to multiple payment 

events, is discussed below. 

H. Delay in Payment by the Service 

Recipient 

Commentators noted that for certain 

compelling reasons, a service recipient 

may be unwilling or unable to make a 

payment of an amount due under a 

nonqualified deferred compensation 

plan. These regulations generally 

provide that in the case of payments the 

deduction for which would be limited 

or eliminated by the application of 

section 162(m), payments that would 

violate securities laws, or payments that 

would violate loan covenants or other 

contractual terms to which the service 

recipient is a party, where such a 

violation would result in material harm 

to the service recipient, the plan may 

provide that the payment will be 

delayed. In addition, plans may be 

amended to add such provisions, but 

such an amendment cannot be effective 

for a period of at least 12 months. 

However, if a plan is amended to 

remove such a provision with respect to 

amounts deferred previously, the 

amendment will constitute an 

acceleration of the payment. In the case 

of amounts for which the deduction 

would be limited or reduced by the 

application of section 162(m), these 

regulations require that the payment be 

deferred either to a date in the first year 

in which the service recipient 

reasonably anticipates that a payment of 

such amount would not result in a 

limitation of a deduction with respect to 

the payment of such amount under 

section 162(m) or the year in which the 

service provider separates from service. 

In the case of amounts that would 

violate loan covenants or similar 

contracts, or would result in a violation 

of Federal securities laws or other 

applicable laws, the arrangement must 

provide that the payment will be made 

in the first calendar year in which the 

service recipient reasonably anticipates 

that the payment would not violate the 

loan contractual terms, the violation 

would not result in material harm to the 

service recipient, or the payment would 

not result in a violation of Federal 

securities law or other applicable laws. 

These regulations also provide that the 

Commissioner may prescribe through 

guidance published in the Internal 

Revenue Bulletin other circumstances in 

which a plan may provide for the delay 

of a payment of a deferred amount. The 

Treasury Department and the IRS 

specifically request comments as to 

what other circumstances may be 

appropriate to include in such guidance. 

I. Disputed Payments and Refusals To 

Pay 

In addition to situations in which a 

plan may delay payment due to certain 

business circumstances, commentators 

expressed concern about the possibility 

that a service recipient will refuse to 

pay deferred compensation when the 

payment is due, and whether such 

refusal to pay would result in taxation 

of the service provider under section 

409A. Generally these situations will 

arise where either the obligation to 

make the payment, or the amount of the 

payment, is subject to dispute. But this 

situation may also arise where the 

service recipient simply refuses to pay. 

In either situation, these proposed 

regulations generally provide that the 

payment will be deemed to be made 

upon the date scheduled under the 

terms of the arrangement, provided that 

the service provider is acting in good 

faith and makes reasonable, good faith 

efforts to collect the amount. Factors 

relevant in determining whether a 

service provider is acting in good faith 

and making reasonable, good faith 

efforts to collect the amount include 

both the amount of the payment, or 

portion of a payment, in dispute, as well 

as the size of the disputed portion in 

relation to the entire payment. Although 

a payment may be delayed under this 

provision without violating section 

409A because the service recipient 

refuses to make the payment, the 

payment may not be made subject to a 

subsequent deferral election because the 

payment was delayed. Rather, the 

payment must be made by the later of 

the end of the calendar year in which, 

or the 15th day of the third month 

following the date that, the service 

recipient and the service provider enter 

into a legally binding settlement of such 

dispute, the service recipient concedes 

that the full amount is payable, or the 

service recipient is required to make 

such payment pursuant to a final and 

nonappealable judgment or other 

binding decision. This paragraph is not 

intended to serve as a means of 

deferring payments without application 

of section 409A, by feigning a dispute or 

surreptitiously requesting that the 

service recipient refuse to pay the 

amount at the due date. Where the 

service provider is not acting in good 

faith, for example creating a dispute 

with no or tenuous basis, or where the 

service provider is not making 

reasonable, good faith efforts to collect 

the amount, the failure to receive the 

payment at the date originally 

scheduled may result in a violation of 

the permissible payment requirements. 

Among the factors to be considered is 

the practice of the service recipient with 

respect to payments of nonqualified 

deferred compensation. In addition, 

these regulations provide that the 

service provider is treated as having 

requested that a payment not be made, 

rather than the service recipient having 

refused to make such payment, where 

the decision that the service recipient 

will not make the payment is made by 

the service provider, or any person or 

group of persons under the supervision 

of the service provider at the time the 

decision is made. 

VII. Anti-Acceleration Provision 

A. In General 

Under section 409A(a)(3), a payment 

of deferred compensation may not be 

accelerated except as provided in 

regulations by the Secretary. Certain 

permissible payment accelerations were 

listed in Notice 2005–1, Q&A–15, 

including payments necessary to 

comply with a domestic relations order, 

payments necessary to comply with 

certain conflict of interest rules, 

payments intended to pay employment 

taxes, and certain de minimis payments 

related to the participant’s termination 

of his or her interest in the plan. All the 

permissible payment accelerations 

contained in Notice 2005–1, Q&A–15, 

are included in these regulations. 

57950 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

B. Payments Upon Income Inclusion 

Under Section 409A 

These regulations provide that a plan 

may permit the acceleration of the time 

or schedule of a payment to a service 

provider to pay the amount the service 

provider includes in income as a result 

of the plan failing to meet the 

requirements of section 409A. For this 

purpose, a service provider will be 

deemed to have included the amount in 

income if the amount is timely reported 

on a Form W–2 ‘‘Wage and Tax 

Statement’’ or Form 1099–MISC 

‘‘Miscellaneous Income’’, as 

appropriate. 

C. Plan Terminations 

Some commentators requested that 

service recipients be allowed to retain 

the right to accelerate payments upon a 

termination of the arrangement, where 

the termination is at the discretion of 

the service recipient. A general ability of 

a service recipient to make such 

payments raises the potential for abuse, 

especially with respect to arrangements 

with individual service providers. 

Where a service provider retains 

sufficient influence to obtain a 

termination of the arrangement, the 

service recipient’s discretion to 

terminate the plan in substance would 

mean that amounts deferred were 

available to the service provider upon 

demand. Such a condition would be 

inconsistent with the provisions of and 

legislative intent behind section 409A. 

Some commentators requested that 

service recipients be permitted to 

terminate arrangements where the 

arrangements are broad-based, covering 

a significant number of service 

providers. Due to concerns about 

administrability and equity, the 

regulations do not adopt the suggestion. 

Some commentators also suggested 

that service recipients be permitted to 

terminate arrangements due to bona fide 

business reasons. However, the Treasury 

Department and the IRS are not 

confident that such a standard could be 

applied on a consistent and coherent 

basis, leaving service recipients unable 

to plan with confidence and creating the 

potential for abuse. The Treasury 

Department and the IRS are considering 

further guidance establishing criteria or 

circumstances under which a plan 

could be terminated. For that purpose, 

these regulations provide authority to 

the Commissioner to establish such 

criteria or circumstances in generally 

applicable guidance published in the 

Internal Revenue Bulletin. 

These proposed regulations provide 

three circumstances under which a plan 

may be terminated at the discretion of 

the service recipient in accordance with 

the terms of the plan. The first addresses 

a service recipient that wants to cease 

providing a certain category of 

nonqualified deferred compensation, 

such as account balance plans, entirely. 

A plan may be terminated provided that 

all arrangements of the same type 

(account balance plans, nonaccount 

balance plans, separation pay plans or 

other arrangements) are terminated with 

respect to all participants, no payments 

other than those otherwise payable 

under the terms of the plan absent a 

termination of the plan are made within 

12 months of the termination of the 

arrangement, all payments are made 

within 24 months of the termination of 

the arrangement, and the service 

recipient does not adopt a new 

arrangement that would be aggregated 

with any terminated arrangement under 

the plan aggregation rules at any time 

for a period of five years following the 

date of termination of the arrangement. 

The remaining two exceptions relate 

to events that are both objectively 

determinable to have occurred—and so 

may be determined consistently—and 

are of such independent significance 

that they are unlikely to be related to 

any attempt to accelerate payments 

under a nonqualified deferred 

compensation plan in a manner 

inconsistent with the intent of the 

statute. These regulations provide that 

during the 12 months following a 

change in control of a corporation, the 

service recipient may elect to terminate 

a plan and make payments to the 

participants. In addition, a plan may 

provide that the plan terminates upon a 

corporate dissolution taxed under 

section 331, or with the approval of a 

bankruptcy court pursuant to 11 U.S.C. 

§ 503(b)(1)(A), provided that the 

amounts deferred under the plan are 

included in the participants’ gross 

incomes by the latest of (i) the calendar 

year in which the plan termination 

occurs, (ii) the calendar year in which 

the amount is no longer subject to a 

substantial risk of forfeiture, or (iii) the 

first calendar year in which the payment 

is administratively practicable. 

D. Terminations of Deferral Elections 

Following an Unforeseeable Emergency 

or a Hardship Distribution 

Commentators noted that although 

section 409A provides that a service 

provider may receive a payment upon 

an unforeseeable emergency, there is no 

provision explicitly permitting or 

requiring the service provider to halt all 

elective deferrals to receive such a 

payment. In addition, commentators 

noted that to receive a hardship 

distribution under a qualified plan with 

a qualified cash or deferred arrangement 

under section 401(k), a participant 

generally would be required pursuant to 

the regulations under section 401(k) to 

halt any elective deferrals of 

compensation into a nonqualified 

deferred compensation plan. In 

response, these regulations provide that 

a plan may provide that a deferral 

election terminates if a service provider 

obtains a payment upon an 

unforeseeable emergency. Similarly, 

these regulations provide that a plan 

may provide that a deferral election is 

terminated if required for a service 

provider to obtain a hardship 

distribution under a qualified plan with 

a qualified cash or deferred arrangement 

under section 401(k). In each case, the 

deferral election must be terminated, 

and not merely suspended. A deferral 

election under the arrangement made 

after a termination of a deferral election 

due to a hardship distribution or an 

unforeseeable emergency will be treated 

as an initial deferral election. 

E. Distributions To Avoid a 

Nonallocation Year Under Section 

409(p) 

Commentators noted that in the case 

of an S corporation sponsoring an 

employee stock ownership plan, under 

certain conditions distributions from a 

nonqualified deferred compensation 

plan may be necessary to avoid a 

nonallocation year (within the meaning 

of section 409(p)(3)). These regulations 

provide rules under which such 

distributions may be made to avoid such 

a nonallocation year. 

VIII. Subsequent Changes in the Time 

and Form of Payment 

A. In General 

Section 409A(a)(4)(C) and these 

regulations provide that, in the case of 

a plan that permits a service provider to 

make a subsequent election to delay a 

payment or to change the form of a 

payment (provided that any such 

payment is the subject of an initial 

deferral election), the following 

conditions must be met: 

(1) The plan must require that such 

election not take effect until at least 12 

months after the date on which the 

election is made, 

(2) In the case of an election related 

to a payment other than a payment on 

account of death, disability or the 

occurrence of an unforeseeable 

emergency, the plan requires that the 

first payment with respect to which 

such election is made be deferred for a 

period of not less than 5 years from the 

date such payment would otherwise 

have been made (the 5-year rule), and 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57951 

(3) The plan requires that any election 

related to a payment at a specified time 

or pursuant to a fixed schedule may not 

be made less than 12 months prior to 

the date of the first scheduled payment. 

B. Definition of Payment 

Commentators requested clarification 

whether the individual amounts paid in 

a defined stream of payments, such as 

installment payments, are treated as 

separate payments or as one payment. 

This affects the application of the rules 

governing subsequent deferral elections, 

particularly the 5-year rule. 

These proposed regulations provide 

generally that each separately identified 

amount to which a service provider is 

entitled to payment under a plan on a 

determinable date is a separate 

payment. Accordingly, if an amount is 

separately identified as a payment, 

either because the right arises under a 

separate arrangement or because the 

arrangement identifies the amount as a 

separate payment, the amount will not 

be aggregated with other amounts for 

purposes of the rules relating to 

subsequent changes in the time and 

form of payment and the antiacceleration rule. For example, an 

arrangement may provide that 50 

percent of the benefit is paid as a lump 

sum at separation from service, and that 

the remainder of the benefit is paid as 

a lump sum at age 60, which would 

identify each amount as a separate 

payment. However, once a payment has 

been identified separately, the payment 

may only be aggregated with another 

payment if the aggregation would 

otherwise comply with the rules relating 

to subsequent changes in the time and 

form of payment and the antiacceleration rule. 

The Treasury Department and the IRS 

recognize that most taxpayers view the 

ability to elect installment payments as 

a choice of a single form of payment. 

Accordingly, the entitlement to a series 

of installment payments under a 

particular arrangement generally is 

treated as a single payment for purposes 

of the subsequent deferral rules. 

However, taxpayers could also view 

each individual payment in the series of 

payments as a separate payment. 

Accordingly, these regulations provide 

that an arrangement may specify that a 

series of installment payments is to be 

treated as a series of separate payments. 

An installment payment must be 

treated consistently both with respect to 

the rules governing subsequent changes 

in the time and form of payment, and 

with respect to the anti-acceleration 

rules. For example, if a 5-year 

installment payment is treated as a 

single payment and is scheduled to 

commence on July 1, 2010, then 

consistent with the 5-year rule a service 

provider generally could change the 

time and form of the payment to a lump 

sum payment on July 1, 2015, provided 

the other conditions related to a change 

in the time and form of payment were 

met. In contrast, if a 5-year installment 

payment is designated as five separate 

payments scheduled for the years 2010 

through 2014, then the service provider 

could not change the time and form of 

the payment to a lump sum payment to 

be made on July 1, 2015 because the 

separate payments scheduled for the 

years 2011 through 2014 would not 

have been deferred at least 5 years. 

Rather, the service provider generally 

could change the time and form of 

payment to a lump sum payment only 

if the payment were scheduled to occur 

no earlier than 2019 (5 years after the 

last of the originally scheduled 

payments). 

One exception to this rule is a life 

annuity, the entitlement to which is 

treated as a single payment. The 

Treasury Department and the IRS 

believe that taxpayers generally view an 

entitlement to a life annuity as a single 

form of payment, rather than a series of 

separate payments. In addition, treating 

a life annuity as a series of payments 

would lead to difficulty in applying the 

rules governing subsequent changes in 

the time and form of payment, because 

the aggregate amount of the payments 

and the duration of the payments are 

unknown, as their continuation depends 

on the continued life of the service 

provider or other individual. For 

example, if a single life annuity were 

treated as a series of separate payments, 

an election to change a form of payment 

to a lump sum payment could be made 

only if the lump sum payment were 

deferred to a date no earlier than five 

years after the death of the participant. 

C. Application to Multiple Payment 

Events 

As discussed above, a plan may 

provide that a payment will be made 

upon the earlier of, or the later of, 

multiple specified permissible payment 

events. In addition, a plan may provide 

for a different form of payment 

depending upon the payment event. For 

example, a plan may provide that a 

service provider is entitled to an 

annuity at age 65 or, if earlier, a lump 

sum payment upon separation from 

service. 

The question then arises as to how the 

provisions governing changes in the 

time and form of payment and the antiacceleration provision apply where 

there are multiple potential payment 

events, and possibly multiple forms of 

payment as well. The regulations 

provide that these provisions are to 

apply to each payment event separately. 

In the example above, these provisions 

would apply separately to the 

entitlement to the installment payment 

at age 65, and the entitlement to the 

lump sum payment at separation from 

service. Accordingly, the service 

provider generally would be able to 

delay the annuity payment date subject 

to the rules governing changes in the 

time and form of payment, while 

retaining a separate right to receive a 

lump sum payment at separation from 

service if that occurred at an earlier 

date. In other words, the 5-year rule 

would apply to the annuity payment 

date (delaying payment from age 65 to 

at least age 70) but not to the unchanged 

lump sum payment available upon 

separation from service before age 70. 

Similarly, a plan may provide that an 

intervening event that is a permissible 

payment event under section 409A may 

override an existing payment schedule 

already in payment status. For example, 

a plan could provide that a participant 

would receive six installment payments 

commencing at separation from service, 

but also provide that if the participant 

died after the payments commenced, all 

remaining benefits would be paid in a 

lump sum. 

An additional question arises where a 

new payment event, or a fixed time or 

fixed schedule of payments, is added to 

the plan. Generally, the addition of the 

payment event or date will be subject to 

the rules governing changes in the time 

and form of payment and the antiacceleration rules. Accordingly, no fixed 

time of payment could be added that 

did not defer the payment at least five 

years from the date the fixed time was 

added. In addition, no payment due to 

any other added permissible event 

could be made within five years of the 

addition of the event. For example, a 

service provider entitled to a payment 

only on January 1, 2050, could not make 

a subsequent deferral election to be paid 

on the later of January 1, 2050, or 

separation from service, but could make 

a subsequent deferral election to be paid 

at the later of separation from service or 

January 1, 2055. 

IX. Application of Rules to 

Nonqualified Deferred Compensation 

Plans Linked to Qualified Plans 

A. In General 

Commentators raised many issues 

concerning the application of section 

409A to nonqualified deferred 

compensation plans linked to qualified 

plans. These linked plans exist in a 

variety of formats, and are referred to 

57952 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

under various labels such as excess 

plans, wrap plans, and supplemental 

employee retirement plans (SERPs). 

Typically the purpose of such plans is 

to replace the benefits that would have 

been provided under the qualified plan 

absent the application of certain limits 

contained in the Code (for example, 

section 415, section 401(a)(17) or 

section 402(g)). Often the amounts 

deferred under the nonqualified 

deferred compensation plan are 

established through an offset formula, 

where the amount deferred equals an 

amount determined under a formula, 

offset by any benefits credited under the 

qualified plan. Because of the close 

relationship between the qualified plan 

and the nonqualified deferred 

compensation plan, sponsor and 

participant actions under the qualified 

plan may affect the calculation or 

payment of the amounts deferred under 

the nonqualified deferred compensation 

plan. Commentators asked for guidance 

regarding the circumstances under 

which an action (or failure to act) under 

the qualified plan may be treated as 

violating section 409A, to the extent the 

action (or failure to act) also affects the 

amounts deferred under the 

nonqualified deferred compensation 

plan. 

These proposed regulations generally 

adopt rules under which nonqualified 

deferred compensation plans linked to 

qualified plans may continue to operate, 

though certain changes may be required. 

The intent of these rules generally is to 

permit the qualified plan to be 

established, amended and operated 

under the rules governing qualified 

plans, without causing the linked 

nonqualified deferred compensation 

plan to violate the rules of section 409A. 

However, the relief provided under 

certain rules to accommodate the linked 

plan structure is not intended to relax 

the rules generally with respect to all of 

the amounts deferred under the 

nonqualified deferred compensation 

plan, simply because a limited portion 

of the amounts deferred may be affected 

by actions under the qualified plan. 

Accordingly, in certain circumstances 

the relief provided relates solely to 

amounts deferred under the 

nonqualified deferred compensation 

plan that do not exceed the applicable 

limit on the qualified plan benefit for 

the taxable year. 

B. Actions That Do Not Constitute 

Deferral Elections or Accelerations 

Where amounts deferred under a 

nonqualified deferred compensation 

plan are linked to the benefits under a 

qualified plan, certain participant 

actions taken with respect to the benefit 

accrued under the qualified plan may 

affect the amounts deferred under the 

nonqualified deferred compensation 

plan. Where the amounts deferred under 

the nonqualified deferred compensation 

plan increase, the issue is whether the 

action taken with respect to the benefit 

accrued under the qualified plan 

constitutes a deferral election. Where 

the amounts deferred under the 

nonqualified deferred compensation 

plan decrease, the issue is whether the 

action taken with respect to the benefit 

accrued under the qualified plan 

constitutes an impermissible 

acceleration of a payment under the 

nonqualified deferred compensation 

plan. 

With respect to the benefits provided 

under the qualified plan, these 

regulations provide generally that 

neither the amendment of the qualified 

plan to increase or decrease such 

benefits under the qualified plan nor the 

cessation of future accruals under the 

qualified plan is treated as a deferral 

election or an acceleration of a payment 

under the nonqualified deferred 

compensation plan. Similarly, the 

addition, removal, increase or reduction 

of a subsidized benefit or ancillary 

benefit under the qualified plan, or a 

participant election with respect to a 

subsidized benefit or ancillary benefit 

under the qualified plan, will not 

constitute either a deferral election or an 

acceleration of a payment under the 

nonqualified deferred compensation, 

even where such action results in an 

increase or decrease in amounts 

deferred under the nonqualified 

deferred compensation plan. 

Additional relief is provided with 

respect to nonqualified deferred 

compensation plans linked to defined 

contribution plans that include a 401(k) 

or similar cash or deferred arrangement. 

Specifically, the regulations provide 

that a service provider’s action or 

inaction under a qualified plan that is 

subject to section 402(g), including an 

adjustment to a deferral election under 

such qualified plan, will not be treated 

as either a deferral election or an 

acceleration of a payment under the 

linked nonqualified deferred 

compensation plan, provided that for 

any given calendar year, the service 

provider’s actions or inactions under the 

qualified plan do not result in an 

increase in the amounts deferred under 

all nonqualified deferred compensation 

plans in which the service provider 

participates in excess of the limit with 

respect to elective deferrals under 

section 402(g) in effect for the year in 

which such actions or inactions occur. 

The Treasury Department and the IRS 

intend for this provision to address 

common arrangements whereby the 

amounts deferred under the 

nonqualified deferred compensation 

plan are linked to amounts deferred 

under a 401(k) arrangement (often 

referred to as 401(k) wrap plans), but 

only to the extent the amount of affected 

deferrals under the nonqualified 

deferred compensation plan does not 

exceed the maximum amount that ever 

could have been electively deferred 

under the qualified plan. 

Similar relief is provided with respect 

to plans involving matching 

contributions. The regulations provide 

that a service provider’s action or 

inaction under a qualified plan with 

respect to elective deferrals or after-tax 

contributions by the service provider to 

the qualified plan that affects the 

amounts that are credited under a 

nonqualified deferred compensation 

arrangement as matching amounts or 

other amounts contingent on service 

provider elective deferrals or after-tax 

contributions will not be treated as 

either a deferral election or an 

acceleration of payment, provided that 

such matching or contingent amounts, 

as applicable, are either forfeited or 

never credited under the nonqualified 

deferred compensation arrangement in 

the absence of such service provider’s 

elective deferral or after-tax 

contribution, and provided the service 

provider’s actions or inactions under the 

qualified plan do not result in an 

increase or decrease in the amounts 

deferred under all nonqualified deferred 

compensation plans in which the 

service provider participates in excess 

of the limit with respect to elective 

deferrals under section 402(g) in effect 

for the year in which such actions or 

inactions occur. Although the section 

402(g) limit applies to elective deferrals, 

rather than matching contributions, the 

Treasury Department and the IRS 

believe that matching contributions in 

excess of 100 percent of the elective 

deferrals of pre-tax contributions or 

after-tax contributions will be rare. 

X. Statutory Effective Dates 

A. Effective Dates—Earned and Vested 

Amounts 

Consistent with Notice 2005–1, Q&A–

16, these regulations provide that an 

amount is considered deferred before 

January 1, 2005, and thus is not subject 

to section 409A, if the service provider 

had a legally binding right to be paid the 

amount and the right to the amount was 

earned and vested as of December 31, 

2004. For these purposes, a right to an 

amount is earned and vested only if the 

amount is not subject to either a 

substantial risk of forfeiture or a 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57953 

requirement to perform further services. 

Some commentators questioned the 

application of section 409A to 

contractual arrangements entered into 

before the enactment of the statute. 

However, the statutory effective date is 

tied to the date the amount is deferred 

and the legislative history states that for 

these purposes, ‘‘an amount is 

considered deferred before January 1, 

2005, if the amount is earned and vested 

before such date.’’ H.R. Conf. Rep. No. 

108–755, at 737 (2004). Accordingly, 

these regulations are consistent with the 

legislative intent that deferred amounts 

that were not earned, or were not 

vested, as of December 31, 2004, are 

subject to the provisions of section 

409A. 

Clarification has been provided with 

respect to when a stock right or similar 

right to compensation will be treated as 

earned and vested. The issue arises 

because often a stock right terminates 

upon a separation from service. 

Taxpayers questioned whether this 

meant that the right had not been earned 

and vested, because future services 

would be required to retain the right. 

These regulations clarify that a stock 

right or similar right will be treated as 

earned and vested by December 31, 

2004, if on or before such date the right 

was either immediately exercisable for a 

payment of cash or substantially vested 

property, or was not forfeitable. 

Accordingly, stock options that on or 

before December 31, 2004, were 

immediately exercisable for 

substantially vested stock generally 

would not be subject to section 409A. In 

contrast, a nonstatutory stock option 

that was immediately exercisable on or 

before December 31, 2004, but only for 

substantially nonvested stock, generally 

would be subject to section 409A. 

B. Effective Dates—Calculation of 

Grandfathered Amount 

For account balance plans and plans 

that are neither account balance plans 

nor nonaccount balance plans (generally 

equity-based compensation), these 

regulations generally retain the method 

of calculating the grandfathered amount 

set forth in Notice 2005–1, Q&A 16. 

Accordingly, for account balance plans 

the grandfathered amount generally will 

equal the vested account balance as of 

December 31, 2004, plus any earnings 

with respect to such amounts. For 

equity-based compensation, the 

grandfathered amount generally will 

equal the payment that would be 

available if the right were exercised on 

December 31, 2004, and any earnings 

with respect to such amount. For this 

purpose, the earnings generally would 

include the increase in the payment 

available due to appreciation in the 

underlying stock. 

Commentators argued that the 

definition of the grandfathered amount 

contained in Notice 2005–1, Q&A 16 

with respect to nonaccount balance 

plans was not sufficiently flexible to 

account for subsequent increases in 

benefits unrelated to any further 

performance of services or increases in 

compensation after December 31, 2004. 

For example, a participant’s benefit may 

increase if the participant becomes 

eligible for a subsidized benefit at a 

specified age that the participant 

reaches after December 31, 2004. In 

response, these proposed regulations 

provide that for nonaccount balance 

plans, the grandfathered amount 

specifically equals the present value as 

of December 31, 2004, of the amount to 

which the service provider would be 

entitled under the plan if the service 

provider voluntarily terminated services 

without cause on December 31, 2004, 

and received a payment of the benefits 

with the maximum value available from 

the plan on the earliest possible date 

allowed under the plan to receive a 

payment of benefits following the 

termination of services. 

Notwithstanding the foregoing, for any 

subsequent calendar year, the 

grandfathered amount may increase to 

equal the present value of the benefit 

the service provider actually becomes 

entitled to, determined under the terms 

of the plan (including applicable limits 

under the Code), as in effect on October 

3, 2004, without regard to any further 

services rendered by the service 

provider after December 31, 2004, or 

any other events affecting the amount 

of, or the entitlement to, benefits (other 

than the participant’s survival or a 

participant election under the terms of 

the plan with respect to the time or form 

of an available benefit). 

Because separation pay plans with 

respect to involuntary terminations and 

window programs are now treated as 

separate plans, these regulations 

provide a rule for calculating the 

grandfathered amount under such plans. 

For these purposes, the principles used 

to calculate the grandfathered amounts 

under a nonaccount balance plan and an 

account balance plan are to be applied 

by analogy, depending upon the 

structure of the separation pay plan. 

C. Material Modifications 

Commentators have pointed out that a 

grandfathered plan may become subject 

to section 409A upon any material 

modification, even if such modification 

occurs many years after 2004. Given the 

substantial amounts of compensation 

that are deferred under grandfathered 

plans, as well as the potential for these 

amounts to grow through accumulated 

grandfathered earnings, the 

consequences of such a modification 

could be significant. Commentators 

expressed concern that as long as these 

plans exist, there will be the potential 

for a change to the plan to mistakenly 

cause the plan to become subject to 

section 409A. In response, these 

regulations include a provision stating 

that to the extent a modification is 

rescinded before the earlier of the date 

any additional right granted under the 

modification is exercised or the end of 

the calendar year in which the 

modification was made, the 

modification will not be treated as a 

material modification of the plan. For 

example, if a subsequent deferral feature 

is added that would allow participants 

to extend the time and form of payment 

of a grandfathered deferred amount, and 

if the right is removed before the earlier 

of the time the participant exercises the 

right or the end of the calendar year, 

then the modification will not be treated 

as a material modification of the plan. 

However, this provision is not intended 

to cover material modifications that are 

made with the knowledge that the 

modification will subject the amounts to 

section 409A, but are then rescinded. 

Consistent with Notice 2005–1, Q&A–

18(a), these regulations also provide that 

it is not a material modification to 

change a notional investment measure 

to, or to add, an investment measure 

that qualifies as a predetermined actual 

investment within the meaning of 

§ 31.3121(v)(2)–1(d)(2) of this chapter. 

Commentators requested similar 

flexibility with respect to investment 

measures reflecting reasonable rates of 

interest. These regulations provide such 

flexibility, generally adopting a 

modified version of the rules contained 

in § 31.3121(v)(2)–1(d)(2) of this 

chapter. Under these regulations, it is 

not a material modification to change a 

notional investment measure to, or to 

add, an investment measure that 

qualifies as a predetermined actual 

investment within the meaning of 

§ 31.3121(v)(2)–1(d)(2) of this chapter 

or, for any given taxable year, reflects a 

reasonable rate of interest. For this 

purpose, if with respect to an amount 

deferred for a period, a plan provides for 

a fixed rate of interest to be credited, 

and the rate is to be reset under the plan 

at a specified future date that is not later 

than the end of the fifth calendar year 

that begins after the beginning of the 

period, the rate is reasonable at the 

beginning of the period, and the rate is 

not changed before the reset date, then 

the rate will be treated as reasonable in 

57954 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

all future periods before the reset date. 

These proposed regulations also contain 

other clarifications of the application of 

the material modification rule. 

XI. Transition Relief 

A. In General 

Until the effective date of these 

regulations, Notice 2005–1 generally 

remains in effect. Notice 2005–1, Q&As18 through 23. provided transition relief 

that was limited to the 2005 calendar 

year. Commentators generally reacted 

favorably to the scope of the transition 

rules. The Treasury Department and the 

IRS intended for the transition rules to 

be generous during the calendar year 

2005, both to enable taxpayers to 

familiarize themselves with the new 

provisions, and also to provide a period 

during which the Treasury Department 

and the IRS could develop regulations 

and taxpayers generally could be 

confident that either their plans were 

not in violation of section 409A, or 

could be corrected to avoid additional 

tax under the statute. 

Because final regulations are not yet 

in place, the IRS and the Treasury 

Department are hereby extending 

through 2006 certain aspects of the 

transition relief provided for 2005 by 

Notice 2005–1. In addition, in response 

to questions, certain provisions of 

Notice 2005–1 are clarified below. 

However, because taxpayers will have 

had, by the end of 2005, over a year to 

implement the statute, certain other 

transition relief is not being extended 

through 2006. 

B. Amendment and Operation of Plans 

Adopted on or Before December 31, 

2006 

Pursuant to Notice 2005–1, Q&A–19, 

a plan adopted on or before December 

31, 2005, will not be treated as violating 

section 409A(a)(2), (3) or (4) only if the 

plan is operated in good faith 

compliance with the provisions of 

section 409A and Notice 2005–1 during 

the calendar year 2005, and the plan is 

amended on or before December 31, 

2005, to conform to the provisions of 

section 409A with respect to amounts 

subject to section 409A. To allow time 

to finalize these regulations, and for 

practitioners to implement the final 

regulations, the deadline by which plan 

documents must be amended to comply 

with the provisions of section 409A and 

the regulations is hereby extended to 

December 31, 2006. Accordingly, in 

order to be treated as complying with 

section 409A(a)(2), (3) or (4), a plan 

adopted before December 31, 2006, must 

be amended on or before December 31, 

2006, either to conform to the 

provisions of section 409A with respect 

to amounts subject to section 409A, or 

to provide a compensation arrangement 

that does not provide for a deferral of 

compensation for purposes of section 

409A. 

The good faith compliance period 

provided under Q&A–19 of Notice 

2005–1 is also hereby extended through 

December 31, 2006. Accordingly, a plan 

adopted on or before December 31, 

2006, will be treated as complying with 

section 409A(a)(2), (3) or (4) only if the 

plan is operated through December 31, 

2006, in good faith compliance with the 

provisions of section 409A and Notice 

2005–1. If any other guidance of general 

applicability under section 409A is 

published in the Internal Revenue 

Bulletin with an effective date prior to 

January 1, 2007, the plan must also 

comply with such published guidance 

as of its effective date. To the extent an 

issue is not addressed in Notice 2005–

1 or such other published guidance, the 

plan must follow a good faith, 

reasonable interpretation of section 

409A, and, to the extent not inconsistent 

therewith, the plan’s terms. 

These regulations are not proposed to 

become effective prior to January 1, 

2007, and, accordingly, a plan is not 

required to comply with either these 

proposed regulations or the final 

regulations prior to January 1, 2007. 

However, compliance with either these 

proposed regulations or the final 

regulations will be good faith 

compliance with the statute. In general, 

these proposed regulations expand 

upon, and should be read consistently 

with, the provisions of Notice 2005–1. 

However, to the extent that a provision 

of either these proposed regulations or 

the final regulations is inconsistent with 

a provision of Notice 2005–1, the plan 

may comply with the provision of the 

proposed or final regulations in lieu of 

the corresponding provision of Notice 

2005–1. 

A plan will not be operating in good 

faith compliance if the plan sponsor 

exercises discretion under the terms of 

the plan, or a service provider exercises 

discretion with respect to that service 

provider’s benefits, in a manner that 

causes the plan to fail to meet the 

requirements of section 409A. For 

example, if an employer retains the 

discretion under the terms of the plan 

to delay or extend payments under the 

plan and exercises such discretion, the 

plan will not be considered to be 

operated in good faith compliance with 

section 409A with regard to any plan 

participant. However, an exercise of a 

right under the terms of the plan by a 

service provider solely with respect to 

that service provider’s benefits under 

the plan, in a manner that causes the 

plan to fail to meet the requirements of 

section 409A, will not be considered to 

result in the plan failing to be operated 

in good faith compliance with respect to 

other participants. For example, the 

request for and receipt of an immediate 

payment permitted under the terms of 

the plan if the participant forfeits 20 

percent of the participant’s benefits (a 

haircut) will be considered a failure of 

the plan to meet the requirements of 

section 409A with respect to that service 

provider, but not with respect to all 

other service providers under the plan. 

C. Change in Payment Elections or 

Conditions on or Before December 31, 

2006 

Notice 2005–1, Q&A–19(c) provided 

generally that with respect to amounts 

subject to section 409A, a plan could be 

amended to provide for new payment 

elections without violating the 

subsequent deferral and antiacceleration rules, provided that the 

plan was amended and the participant 

made the election on or before 

December 31, 2005. The period during 

which a plan may be amended and a 

service provider may be permitted to 

change payment elections, without 

resulting in an impermissible 

subsequent deferral or acceleration, is 

hereby extended through December 31, 

2006, except that a service provider 

cannot in 2006 change payment 

elections with respect to payments that 

the service provider would otherwise 

receive in 2006, or to cause payments to 

be made in 2006. Other provisions of 

the Internal Revenue Code and common 

law doctrines continue to apply to any 

such election. 

Accordingly, with respect to amounts 

subject to section 409A and amounts 

that would be treated as a short-term 

deferral within the meaning of 

§ 1.409A–1(b)(4), a plan may provide, or 

be amended to provide, for new 

payment elections on or before 

December 31, 2006, with respect to both 

the time and form of payment of such 

amounts and the election will not be 

treated as a change in the form and 

timing of a payment under section 

409A(a)(4) or an acceleration of a 

payment under section 409A(a)(3), 

provided that the plan is so amended 

and the service provider makes any 

applicable election on or before 

December 31, 2006, and provided that 

the amendment and election applies 

only to amounts that would not 

otherwise be payable in 2006 and does 

not cause an amount to be paid in 2006 

that would not otherwise be payable in 

such year. Similarly, an outstanding 

stock right that provides for a deferral of 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57955 

compensation subject to section 409A 

may be amended to provide for fixed 

payment terms consistent with section 

409A, or to permit holders of such rights 

to elect fixed payment terms consistent 

with section 409A, and such 

amendment or election will not be 

treated as a change in the time and form 

of a payment under section 409A(a)(4) 

or an acceleration of a payment under 

section 409A(a)(3), provided that the 

option or right is so amended and any 

elections are made, on or before 

December 31, 2006. 

D. Payments Based Upon an Election 

Under a Qualified Plan for Periods 

Ending on or Before December 31, 2006 

For calendar year 2005, Notice 2005–

1 Q&A–23 provides relief for 

nonqualified deferred compensation 

plans where the time and form of 

payment is controlled by the time and 

form of payment elected by the service 

provider under a qualified plan. 

Commentators indicated that this is a 

common arrangement with respect to 

nonqualified deferred compensation 

plans providing benefits calculated in 

relation to benefits accrued under a 

defined benefit qualified plan. 

Generally, the provisions with respect to 

the election of a time and form of a 

payment with respect to a qualified plan 

benefit would not comply with the 

requirements of section 409A were the 

plan subject to section 409A. 

Accordingly, election provisions under 

a nonqualified plan that mirrored or 

depended upon an election under a 

qualified plan generally would not 

comply with section 409A. The 

Treasury Department and the IRS were 

concerned that service providers, 

service recipients and plan 

administrators would not have 

sufficient time to solicit, retain and 

process new elections from service 

providers to comply with section 409A 

in 2005. Accordingly, relief was 

provided in Notice 2005–1, Q&A–23, 

under which an election under a 

nonqualified deferred compensation 

plan that was controlled by an election 

under a qualified plan could continue in 

effect during the calendar year 2005. 

Commentators requested that this 

relief be a permanent provision in the 

regulations. Although the Treasury 

Department and the IRS understand that 

such a provision would make the 

coordination of benefits under a 

qualified plan and benefits under a 

nonqualified deferred compensation 

plan calculated by reference to the 

qualified plan benefits easier to 

administer, the provisions of section 

409A are not as flexible with respect to 

the timing of such elections as the 

qualified plan provisions. Given that the 

benefits under a nonqualified deferred 

compensation plan often dwarf the 

benefits provided under a qualified 

plan, the Treasury Department and the 

IRS do not believe that the importation 

of the more flexible qualified plan rules 

would be consistent with the legislative 

intent behind the enactment of section 

409A. Accordingly, the transition relief 

has not been made permanent. 

However, because other transition relief 

granting a participant the ability to 

change a time and form of payment 

through the end of the calendar year 

2006 would, in many instances, allow a 

participant to elect the same time and 

form of payment that had been elected 

under the qualified plan, the relief is 

hereby extended through the calendar 

year 2006. 

Accordingly, for periods ending on or 

before December 31, 2006, an election as 

to the timing and form of a payment 

under a nonqualified deferred 

compensation plan that is controlled by 

a payment election made by the service 

provider or beneficiary of the service 

provider under a qualified plan will not 

violate section 409A, provided that the 

determination of the timing and form of 

the payment is made in accordance with 

the terms of the nonqualified deferred 

compensation plan as of October 3, 

2004, that govern payments. For this 

purpose, a qualified plan means a 

retirement plan qualified under section 

401(a). For example, where a 

nonqualified deferred compensation 

plan provides as of October 3, 2004, that 

the time and form of payment to a 

service provider or beneficiary will be 

the same time and form of payment 

elected by the service provider or 

beneficiary under a related qualified 

plan, it will not be a violation of section 

409A for the plan administrator to make 

or commence payments under the 

nonqualified deferred compensation 

plan on or after January 1, 2005, and on 

or before December 31, 2006, pursuant 

to the payment election under the 

related qualified plan. Notwithstanding 

the foregoing, other provisions of the 

Internal Revenue Code and common law 

tax doctrines continue to apply to any 

election as to the timing and form of a 

payment under a nonqualified deferred 

compensation plan. 

E. Initial Deferral Elections 

Notice 2005–1, Q&A–21 provides 

relief with respect to initial deferral 

elections, generally permitting initial 

deferral elections with respect to 

deferrals relating all or in part to 

services performed on or before 

December 31, 2005, to be made on or 

before March 15, 2005. No extension is 

provided with respect to this relief with 

respect to initial elections to defer 

compensation. The Treasury 

Department and the IRS believe that 

sufficient guidance has been provided 

so that timely elections may be solicited 

and received from plan participants. In 

combination with the extension of 

flexibility with respect to amending the 

time and form of payments, the 

Treasury Department and the IRS 

believe that participants should be 

sufficiently informed to make a decision 

with respect to deferral elections. 

F. Cancellation of Deferrals and 

Termination of Participation in a Plan 

Notice 2005–1, Q&A–20 provides a 

limited time during which a plan 

adopted before December 31, 2005, may 

provide a participant a right to 

terminate participation in the plan, or 

cancel an outstanding deferral election 

with regard to amounts subject to 

section 409A. Generally to qualify for 

this relief, if a plan amendment is 

necessary to permit the participant to 

terminate participation or cancel a 

deferral election, the plan amendment 

must be enacted and effective on or 

before December 31, 2005, and whether 

or not the plan is amended, the amount 

subject to the termination or 

cancellation must be includible in 

income of the participant in the 

calendar year 2005 or, if later, in the 

taxable year in which the amounts are 

earned and vested. 

The period during which a service 

provider may cancel a deferral election 

or terminate participation in the plan is 

not extended. This relief was intended 

as a temporary period during which 

service providers could decide whether 

to continue to participate in an 

arrangement subject to section 409A. 

The Treasury Department and the IRS 

believe that the statute and existing 

guidance provide sufficient information 

for service providers to determine by 

December 31, 2005, whether to continue 

to participate in a particular 

arrangement, and that the further 

extension of this relief, and the 

relaxation of constructive receipt rules it 

entails, is not appropriate. 

A termination or cancellation 

pursuant to Notice 2005–1, Q&A–20 is 

treated as effective as of January 1, 2005, 

for purposes of section 409A, and may 

apply in whole or in part to one or more 

plans in which a service provider 

participates and to one or more 

outstanding deferral elections the 

service provider has made with regard 

to amounts subject to section 409A. The 

exercise of a stock option, stock 

appreciation right or similar equity 

appreciation right that provides for a 

57956 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

deferral of compensation, on or before 

December 31, 2005, will be treated as a 

cancellation of a deferral. 

G. Terminations of Grandfathered Plans 

Notice 2005–1, Q&A–18(c) provides 

that amending an arrangement on or 

before December 31, 2005, to terminate 

the arrangement and distribute the 

amounts of deferred compensation 

thereunder will not be treated as a 

material modification, provided that all 

amounts deferred under the plan are 

included in income in the taxable year 

in which the termination occurs. For the 

same reasons discussed above with 

respect to the period during which 

plans may allow participants to 

terminate participation in a plan, the 

relief provided in Notice 2005–1, Q&A–

18(c) is not extended. 

To qualify for the relief provided in 

Notice 2005–1, Q&A–18(c), the 

amendment to the plan must result in 

the termination of the arrangement and 

the distribution of all amounts deferred 

under the arrangement in the taxable 

year of such termination. An 

amendment to a plan to provide a 

participant a right to elect whether to 

terminate participation in the plan or to 

continue to defer amounts under the 

plan would not be covered by Q&A–

18(c), and therefore would constitute a 

material modification of the plan. 

Accordingly, amounts that were not 

distributed pursuant to such an election 

and continued to be deferred under the 

plan would be subject to section 409A. 

H. Substitutions of Non-discounted 

Stock Options and Stock Appreciation 

Rights for Discounted Stock Options 

and Stock Appreciation Rights 

Notice 2005–1, Q&A–18(d) provides 

that it will not be a material 

modification to replace a stock option or 

stock appreciation right otherwise 

providing for a deferral of compensation 

under section 409A with a stock option 

or stock appreciation right that would 

not have constituted a deferral of 

compensation under section 409A if it 

had been granted upon the original date 

of grant of the replaced stock option or 

stock appreciation right, provided that 

the cancellation and reissuance occurs 

on or before December 31, 2005. The 

period during which the cancellation 

and reissuance may occur is extended 

until December 31, 2006, but only to the 

extent such cancellation and reissuance 

does not result in the cancellation of a 

deferral in exchange for cash or vested 

property in 2006. For example, a 

discounted option generally may be 

replaced through December 31, 2006 

with an option that would not have 

provided for a deferral of compensation, 

although the exercise of such a 

discounted option in 2006 before the 

cancellation and replacement generally 

would result in a violation of section 

409A. 

Commentators pointed out that this 

relief could be interpreted as failing to 

cover discounted stock options or stock 

appreciation rights that were not earned 

and vested before January 1, 2005. 

Where replacement stock options or 

stock appreciation rights that would not 

constitute deferred compensation 

subject to section 409A are issued in 

accordance with the conditions set forth 

in Notice 2005–1, Q&A 18(d) and this 

preamble, such replacement stock 

options or stock appreciation rights will 

be treated for purposes of section 409A 

as if granted on the grant date of the 

original stock option or stock 

appreciation right. For example, 

provided that the conditions of Notice 

2005–1, Q&A–18(d) and this preamble 

are met, a discounted stock option 

granted in 2003 that was not earned and 

vested before January 1, 2005, may be 

replaced with a stock option with an 

exercise price that would not have been 

discounted as of the original 2003 grant 

date, and the substituted stock option 

will be treated for purposes of section 

409A as granted on the original 2003 

grant date. Accordingly, if the 

substituted stock option would not have 

been subject to section 409A had it been 

granted on the original 2003 grant date, 

the substituted stock option will not be 

subject to section 409A. 

Commentators noted that some 

service recipients may wish to 

compensate the service provider for the 

lost discount. Commentators proposed 

three methods to provide such 

compensation. First, the service 

recipient may wish to pay the amount 

of the discount in 2005 in cash. As a 

cancellation of a deferral of 

compensation on or before December 

31, 2005 pursuant to Notice 2005–1, 

Q&A–20(a), this payment would not be 

subject to section 409A. Note that as a 

payment due to the cancellation of a 

deferral, such a payment could not be 

made in 2006 as this relief has not been 

extended beyond December 31, 2005. 

Where the stock option remains 

nonvested during the year of the option 

substitution, the service recipient may 

wish to make the compensation for the 

lost discount also subject to a vesting 

requirement. In that case, commentators 

also proposed granting restricted stock 

with a fair market value equal to the lost 

discount, subject to a vesting schedule 

parallel to the vesting schedule of the 

substituted option. As a transfer of 

property subject to section 83 that 

becomes substantially vested after the 

year of substitution, this grant would 

not be subject to section 409A. Finally, 

commentators proposed establishing a 

separate plan, promising a payment of 

the lost discount (plus earnings) subject 

to a vesting schedule parallel to the 

vesting schedule of the substituted 

option. Provided the right to the 

payment becomes substantially vested 

in a future year and otherwise meets the 

requirement of the short-term deferral 

exception in these regulations, the right 

to this payment would not constitute 

deferred compensation subject to 

section 409A. Alternatively, such an 

arrangement could itself provide for 

deferral of compensation beyond the 

year of substantial vesting and be 

subject to the requirements of section 

409A, but if such requirements are met, 

would not affect the exclusion of the 

amended stock option or stock 

appreciation right from the treatment as 

a deferral of compensation subject to 

section 409A. 

XII. Calculation and Timing of Income 

Inclusion Amounts 

To more rapidly issue guidance 

necessary to allow service recipients to 

comply with section 409A, the Treasury 

Department and the IRS have not 

included in these regulations guidance 

with respect to the calculation of the 

amounts of deferrals, or of the amounts 

of income inclusion upon the violation 

of the provisions of section 409A and 

these regulations, or the timing of the 

inclusion of income and related 

withholding obligations. The Treasury 

Department and the IRS anticipate that 

these topics will be addressed in 

subsequent guidance. The Treasury 

Department and the IRS request 

comments with respect to the 

calculation and timing of the income 

inclusion under section 409A, and 

specifically request comments in two 

areas. 

First, section 409A generally requires 

that for any taxable year in which an 

amount is deferred under a plan that 

fails to meet certain requirements, all 

amounts deferred must be included in 

income. This provision generally treats 

earnings (whether actual or notional) as 

amounts deferred subject to the 

inclusion provision. Service providers 

may experience negative earnings in a 

calendar year, such that the amounts to 

which a service provider has a right in 

a particular year are less than the 

amounts to which a service provider 

had a right in a previous year, even 

where no actual payments have been 

made. The Treasury Department and the 

IRS request comments with respect to 

whether and how such negative 

earnings may be accounted for in 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57957 

determining the amount of deferrals and 

the amount of income inclusion for a 

given taxable year, particularly where 

continuing violations of section 409A 

extend to successive tax years. 

Second, the Treasury Department and 

the IRS understand that a method of 

calculation of current deferrals and of 

amounts to be included in income is 

needed for service recipients to meet 

their reporting and withholding 

obligations. Comments are requested as 

to what transitional relief may be 

appropriate depending upon when such 

future guidance is released. For interim 

guidance regarding the information 

reporting and wage withholding 

requirements applicable to deferrals of 

compensation within the meaning of 

section 409A, see Notice 2005–1, Q&A–

24 through Q&A–38. Until further 

guidance is provided, taxpayers may 

rely on Notice 2005–1 regarding 

information reporting and wage 

withholding obligations. 

XIII. Funding Arrangements 

Section 409A(b)(1) provides certain 

tax consequences for the funding of 

deferrals of compensation in offshore 

trusts (or other arrangements 

determined by the Secretary) or 

pursuant to a change in the financial 

health of the employer. The 

consequences of such funding are 

generally consistent with a violation of 

section 409A with respect to funded 

amounts. The Treasury Department and 

the IRS intend to address these 

provisions in future guidance. 

Commentators have requested guidance 

with respect to when assets will be 

treated as set aside, especially with 

respect to service recipients that are, or 

include, foreign corporations. 

Comments are requested as to what 

types of arrangements, other than actual 

trusts, should be treated similarly to 

trusts. In addition, these proposed 

regulations provide guidance with 

respect to the types of arrangements that 

constitute deferred compensation 

subject to section 409A. Because the 

funding rules of section 409A(b) apply 

only to amounts set aside to fund 

deferred compensation subject to 

section 409A, many issues raised by 

commentators with respect to foreign 

arrangements and funding may be 

addressed or limited through the 

definition of deferred compensation 

contained in these proposed regulations. 

Proposed Effective Date 

These regulations are proposed to be 

generally applicable for taxable years 

beginning on or after January 1, 2007. 

As discussed, taxpayers may rely on 

these proposed regulations until the 

effective date of the final regulations. 

Effect on Other Documents 

These proposed regulations do not 

affect the applicability of other guidance 

issued with respect to section 409A, 

including Notice 2005–1 (2005–2 I.R.B. 

274 (published as modified on January 

6, 2005)). However, upon the effective 

date of the final regulations, the 

Treasury Department and the IRS 

anticipate that Notice 2005–1 and 

certain other published guidance will 

become obsolete for periods after the 

effective date of the final regulations. 

Special Analyses 

It has been determined that this notice 

of proposed rulemaking is not a 

significant regulatory action as defined 

in Executive Order 12866. Therefore, a 

regulatory assessment is not required. It 

has also been determined that section 

553(b) of the Administrative Procedure 

Act (5 U.S.C. chapter 5) does not apply 

to these regulations, and because the 

regulation does not impose a collection 

of information on small entities, the 

Regulatory Flexibility Act (5 U.S.C. 

chapter 6) does not apply. Pursuant to 

section 7805(f) of the Code, this notice 

of proposed rulemaking will be 

submitted to the Chief Counsel for 

Advocacy of the Small Business 

Administration for comment on its 

impact on small business. 

Comments and Public Hearing 

Before these proposed regulations are 

adopted as final regulations, 

consideration will be given to any 

written (a signed original and eight (8) 

copies) or electronic comments that are 

submitted timely to the IRS. The IRS 

and Treasury Department request 

comments on the clarity of the proposed 

rules and how they can be made easier 

to understand. All comments will be 

available for public inspection and 

copying. 

A public hearing has been scheduled 

for January 25, 2006, beginning at 10 

a.m. in the Auditorium of the Internal 

Revenue Building, 1111 Constitution 

Avenue, NW., Washington, DC. Due to 

building security procedures, visitors 

must enter at the Constitution Avenue 

entrance. In addition, all visitors must 

present photo identification to enter the 

building. Because of access restrictions, 

visitors will not be admitted beyond the 

immediate entrance area more than 30 

minutes before the hearing starts. For 

information about having your name 

placed on the building access list to 

attend the hearing, see the FOR FURTHER

INFORMATION CONTACT section of this 

preamble. 

The rules of 26 CFR 601.601(a)(3) 

apply to the hearing. Persons who wish 

to present oral comments at the hearing 

must submit written or electronic 

comments and an outline of the topics 

to be discussed and the time to be 

devoted to each topic (a signed original 

and eight (8) copies) by January 4, 2006. 

A period of 10 minutes will be allotted 

to each person for making comments. 

An agenda showing the scheduling of 

the speakers will be prepared after the 

deadline for receiving outlines has 

passed. Copies of the agenda will be 

available free of charge at the hearing. 

Drafting Information 

The principal author of these 

regulations is Stephen Tackney of the 

Office of Division Counsel/Associate 

Chief Counsel (Tax Exempt and 

Government Entities). However, other 

personnel from the IRS and the Treasury 

Department participated in their 

development. 

List of Subjects 26 CFR Part 1 

Income taxes, Reporting and 

recordkeeping requirements. 

Proposed Amendment to the 

Regulations. 

Paragraph 1. The authority citation 

for part 1 continues to read in part as 

follows: 

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

Par. 2. Sections 1.409A–1 through 

1.409A–6 are added to read as follows: 

§ 1.409A–1 Definitions and covered 

arrangements. 

(a) Nonqualified deferred 

compensation plan—(1) In general. 

Except as otherwise provided in this 

paragraph (a), the term nonqualified 

deferred compensation plan means any 

plan (within the meaning of paragraph 

(c) of this section) that provides for the 

deferral of compensation (within the 

meaning of paragraph (b) of this 

section). 

(2) Qualified employer plans. The 

term nonqualified deferred 

compensation plan does not include—

(i) Any plan described in section 

401(a) that includes a trust exempt from 

tax under section 501(a); 

(ii) Any annuity plan described in 

section 403(a); 

(iii) Any annuity contract described in 

section 403(b); 

(iv) Any simplified employee pension 

(within the meaning of section 408(k)); 

(v) Any simple retirement account 

(within the meaning of section 408(p); 

(vi) Any arrangement under which an 

active participant makes deductible 

contributions to a trust described in 

section 501(c)(18); 

57958 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

(vii) Any eligible deferred 

compensation plan (within the meaning 

of section 457(b)); and 

(viii) Any plan described in section 

415(m). 

(3) Certain foreign plans—(i) 

Participation addressed by treaty. With 

respect to an individual for a taxable 

year, the term nonqualified deferred 

compensation plan does not include 

any scheme, trust or arrangement 

maintained with respect to such 

individual, where contributions made 

by or on behalf of such individual to 

such scheme, trust or arrangement are 

excludable by such individual for 

Federal income tax purposes pursuant 

to any bilateral income tax convention 

to which the United States is a party. 

(ii) Participation by nonresident 

aliens and certain resident aliens. With 

respect to an alien individual for a 

taxable year during which such 

individual is a nonresident alien or a 

resident alien classified as a resident 

alien solely under section 

7701(b)(1)(A)(ii) (and not section 

7701(b)(1)(A)(i)), the term nonqualified 

deferred compensation plan does not 

include any broad-based foreign 

retirement plan (within the meaning of 

paragraph (a)(3)(v) of this section) 

maintained by a person that is not a 

United States person. 

(iii) Participation by U.S. citizens and 

lawful permanent residents. With 

respect to an individual for a given 

taxable year during which such 

individual is a U.S. citizen or a resident 

alien classified as a resident alien under 

section 7701(b)(1)(A)(i), and is not 

eligible to participate in a qualified 

employer plan described in paragraph 

(a)(2) of this section, the term 

nonqualified deferred compensation 

plan does not include a broad-based 

foreign retirement plan (within the 

meaning of paragraph (a)(3)(v) of this 

section) maintained by a service 

recipient that is not a United States 

person, but only with respect to 

nonelective deferrals of foreign earned 

income (as defined in section 911(b)(1)) 

and only to the extent that the amounts 

deferred under such plan in such 

taxable year do not exceed the 

applicable limits under section 415(b) 

and (c) that would be applicable if such 

plan were a plan subject to section 415 

and the foreign earned income of such 

individual were treated as 

compensation for purposes of applying 

section 415(b) and (c). 

(iv) Plans subject to a totalization 

agreement and similar plans. The term 

nonqualified deferred compensation 

plan does not include any social 

security system of a jurisdiction to the 

extent that benefits provided under or 

contributions made to the system are 

subject to an agreement entered into 

pursuant to section 233 of the Social 

Security Act with any foreign 

jurisdiction. In addition, the term 

nonqualified deferred compensation 

plan does not include a social security 

system of a foreign jurisdiction to the 

extent that benefits are provided under 

or contributions are made to a 

government-mandated plan as part of 

that foreign jurisdiction’s social security 

system. 

(v) Broad-based retirement plan. For 

purposes of this paragraph (a)(3), the 

term broad-based retirement plan means 

a scheme, trust or arrangement that—

(A) Is written; 

(B) In the case of an employermaintained plan, is nondiscriminatory 

insofar as it (alone or in combination 

with other comparable plans) covers a 

wide range of employees, substantially 

all of whom are nonresident aliens or 

resident aliens classified as resident 

aliens solely under section 

7701(b)(1)(A)(ii) (and not section 

7701(b)(1)(A)(i)), including rank and file 

employees, and actually provides 

significant benefits for the range of 

covered employees; 

(C) In the case of an employermaintained plan, contains provisions 

that generally limit the employees’

ability to use plan benefits for purposes 

other than retirement or restrict access 

to plan benefits prior to separation from 

service, such as restricting in-service 

distributions except in events similar to 

an unforeseeable emergency (as defined 

in § 1.409A–3(g)(3)(i)) or hardship (as 

defined for purposes of section 

401(k)(2)(B)(i)(IV)), and in all cases is 

subject to tax or plan provisions that 

discourage participants from using the 

assets for purposes other than 

retirement; and 

(D) Provides for payment of a 

reasonable level of benefits at death, a 

stated age, or an event related to work 

status, and otherwise requires minimum 

distributions under rules designed to 

ensure that any death benefits provided 

to the participants’ survivors are merely 

incidental to the retirement benefits 

provided to the participants. 

(vi) Participation by a nonresident 

alien—de minimis amounts. With 

respect to a nonresident alien, the term 

nonqualified deferred compensation 

plan does not include any foreign plan 

maintained by a service recipient that is 

not a United States person for a taxable 

year, to the extent that the amounts 

deferred under the foreign plan based 

upon the nonresident alien’s services 

performed in the United States 

(including compensation received due 

to services performed in the United 

States) do not exceed $10,000 in the 

taxable year. 

(4) Section 457 plans. A nonqualified 

deferred compensation plan under 

section 457(f) may constitute a 

nonqualified deferred compensation 

plan for purposes of this paragraph (a). 

The rules of section 409A apply to 

nonqualified deferred compensation 

plans separately and in addition to any 

requirements applicable to such plans 

under section 457(f). In addition, 

nonelective deferred compensation of 

nonemployees described in section 

457(e)(12) and a grandfathered plan or 

arrangement described in § 1.457–

2(k)(4) may constitute a nonqualified 

deferred compensation plan for 

purposes of this paragraph (a). The term 

nonqualified deferred compensation 

plan does not include a length of service 

award to a bona fide volunteer under 

section 457(e)(11)(A)(ii). 

(5) Certain welfare benefits. The term 

nonqualified deferred compensation 

plan does not include any bona fide 

vacation leave, sick leave, compensatory 

time, disability pay, or death benefit 

plan. For these purposes, the term 

disability pay has the same meaning as 

provided in § 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 

§ 31.3121(v)(2)–1(b)(4)(iv)(C) of this 

chapter. The term nonqualified deferred 

compensation plan also does not 

include any Archer Medical Savings 

Account as described in section 220, 

any Health Savings Account as 

described in section 223, or any other 

medical reimbursement arrangement, 

including a health reimbursement 

arrangement, that satisfies the 

requirements of section 105 and section 

106. 

(b) Deferral of compensation—(1) In 

general. Except as otherwise provided 

in paragraphs (b)(3) through (b)(9) of 

this section, a plan provides for the 

deferral of compensation if, under the 

terms of the plan and the relevant facts 

and circumstances, the service provider 

has a legally binding right during a 

taxable year to compensation that has 

not been actually or constructively 

received and included in gross income, 

and that, pursuant to the terms of the 

plan, is payable to (or on behalf of) the 

service provider in a later year. A 

service provider does not have a legally 

binding right to compensation if that 

compensation may be reduced 

unilaterally or eliminated by the service 

recipient or other person after the 

services creating the right to the 

compensation have been performed. 

However, if the facts and circumstances 

indicate that the discretion to reduce or 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57959 

eliminate the compensation is available 

or exercisable only upon a condition, or 

the discretion to reduce or eliminate the 

compensation lacks substantive 

significance, a service provider will be 

considered to have a legally binding 

right to the compensation. Whether the 

negative discretion lacks substantive 

significance depends on the facts and 

circumstances of the particular 

arrangement. However, where the 

service provider to whom the 

compensation may be paid has effective 

control of the person retaining the 

discretion to reduce or eliminate the 

compensation, or has effective control 

over any portion of the compensation of 

the person retaining the discretion to 

reduce or eliminate the compensation, 

or is a member of the family (as defined 

in section 267(c)(4) applied as if the 

family of an individual includes the 

spouse of any member of the family) of 

the person retaining the discretion to 

reduce or eliminate the compensation, 

the discretion to reduce or eliminate the 

compensation will not be treated as 

having substantive significance. For this 

purpose, compensation is not 

considered subject to unilateral 

reduction or elimination merely because 

it may be reduced or eliminated by 

operation of the objective terms of the 

plan, such as the application of an 

objective provision creating a 

substantial risk of forfeiture. Similarly, 

a service provider does not fail to have 

a legally binding right to compensation 

merely because the amount of 

compensation is determined under a 

formula that provides for benefits to be 

offset by benefits provided under a plan 

that is qualified under section 401(a), or 

because benefits are reduced due to 

actual or notional investment losses, or 

in a final average pay plan, subsequent 

decreases in compensation. 

(2) Earnings. References to the 

deferral of compensation include 

references to earnings. When the right to 

earnings is specified under the terms of 

the arrangement, the legally binding 

right to earnings arises at the time of the 

deferral of the compensation to which 

the earnings relate. However, a plan 

may provide that the right to the 

earnings is treated separately from the 

right to the underlying compensation. 

For example, provided that the rules of 

section 409A are otherwise met, a plan 

may provide that earnings will be paid 

at a separate time or in a separate form 

from the payment of the underlying 

compensation. For the application of the 

deferral election rules to current 

payments of earnings and dividend 

equivalents, see § 1.409A–2(a)(13). 

(3) Compensation payable pursuant to 

the service recipient’s customary 

payment timing arrangement. A deferral 

of compensation does not occur solely 

because compensation is paid after the 

last day of the service provider’s taxable 

year pursuant to the timing arrangement 

under which the service recipient 

normally compensates service providers 

for services performed during a payroll 

period described in section 3401(b), or 

with respect to a non-employee service 

provider, a period not longer than the 

payroll period described in section 

3401(b) or if no such payroll period 

exists, a period not longer than the 

earlier of the normal timing arrangement 

under which the service provider 

normally compensates non-employee 

service providers or 30 days after the 

end of the service provider’s taxable 

year. 

(4) Short-term deferrals—(i) In 

general. A deferral of compensation 

does not occur if, absent an election by 

the service provider (including an 

election under § 1.409A–2(a)(4)) to 

otherwise defer the payment of the 

compensation to a later period, an 

amount of compensation is actually or 

constructively received by the service 

provider by the later of the 15th day of 

the third month following the service 

provider’s first taxable year in which the 

amount is no longer subject to a 

substantial risk of forfeiture or the 15th 

day of the third month following the 

end of the service recipient’s first 

taxable year in which the amount is no 

longer subject to a substantial risk of 

forfeiture. In addition, the arrangement 

must not otherwise defer the payment to 

a later period. For example, an 

arrangement that deferred a payment 

until 5 years after the lapsing of a 

condition that constituted a substantial 

risk of forfeiture would constitute a 

deferral of compensation even if the 

amount were actually paid on the date 

the substantial risk of forfeiture lapsed. 

For these purposes, an amount that is 

never subject to a substantial risk of 

forfeiture is considered to be no longer 

subject to a substantial risk of forfeiture 

on the first date the service provider has 

a legally binding right to the amount. 

For example, an employer with a 

calendar year taxable year who on 

November 1, 2008, awards a bonus so 

that the employee is considered to have 

a legally binding right to the payment as 

of November 1, 2008, will not be 

considered to have provided for a 

deferral of compensation if, absent an 

election to otherwise defer the payment, 

the amount is paid or made available to 

the employee on or before March 15, 

2009. An employer with a taxable year 

ending August 31 who on November 1, 

2008, awards a bonus so that the 

employee is considered to have a legally 

binding right to the payment as of 

November 1, 2008, will not be 

considered to have provided for a 

deferral of compensation if, absent an 

election to otherwise defer the payment, 

the amount is paid or made available to 

the employee on or before November 15, 

2009. 

(ii) Delayed payments due to 

unforeseeable events. A payment that 

otherwise qualifies as a short-term 

deferral under paragraph (b)(4)(i) of this 

section but is made after the 15th day 

of the third month following the end of 

the relevant taxable year (the applicable 

21⁄2 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 21⁄2 month period or that 

making the payment by the end of the 

applicable 21⁄2 month period would 

have jeopardized the solvency of the 

service recipient, and, as of the date 

upon which the legally binding right to 

the compensation arose, such 

impracticability or insolvency was 

unforeseeable, and also the payment is 

made as soon as reasonably practicable. 

For example, an amount that would 

otherwise qualify as a short-term 

deferral except that the payment is 

made after the applicable 21⁄2 month 

period may continue to qualify as a 

short-term deferral under this paragraph 

(b)(4) to the extent that the delay is 

caused either because the funds of the 

service recipient were not sufficient to 

make the payment before the end of the 

applicable 21⁄2 month period without 

jeopardizing the solvency of the service 

recipient, or because it was not 

reasonably possible to determine by the 

end of the applicable 21⁄2 month period 

whether payment of such amount was to 

be made, and the circumstance causing 

the delay was unforeseeable as of the 

date upon which the legally binding 

right to the compensation arose. Thus, 

the amount will not continue to qualify 

as a short-term deferral to the extent it 

was foreseeable, as of date upon which 

the legally binding right to the 

compensation arose, that the amount 

would not be paid within the applicable 

21⁄2 month period. For purposes of this 

paragraph (b)(4)(ii), an action or failure 

to act of the service provider or a person 

under the service provider’s control, 

such as a failure to provide necessary 

information or documentation, is not an 

unforeseeable event. 

(5) Stock options, stock appreciation 

rights and other equity-based 

compensation—(i) Stock rights—(A) 

Nonstatutory stock options not 

providing for the deferral of 

57960 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

compensation. An option to purchase 

service recipient stock does not provide 

for a deferral of compensation if—

(1) The amount required to purchase 

stock under the option (the exercise 

price) may never be less than the fair 

market value of the underlying stock 

(disregarding lapse restrictions as 

defined in § 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 § 1.83–7; and 

(3) The option does not include any 

feature for the deferral of compensation 

other than the deferral of recognition of 

income until the later of exercise or 

disposition of the option under § 1.83–

7, or the time the stock acquired 

pursuant to the exercise of the option 

first becomes substantially vested (as 

defined in § 1.83–3(b)). 

(B) Stock appreciation rights not 

providing for the deferral of 

compensation. A right to compensation 

equal to the appreciation in value of a 

specified number of shares of stock of 

the service recipient occurring between 

the date of grant and the date of exercise 

of such right (a stock appreciation right) 

does not provide for a deferral of 

compensation if—

(1) Compensation payable under the 

stock appreciation right cannot be 

greater than the difference between the 

fair market value of the stock 

(disregarding lapse restrictions as 

defined in § 1.83–3(i)) on the date of 

grant of the stock appreciation right and 

the fair market value of the stock 

(disregarding lapse restrictions as 

defined in § 1.83–3(i)) on the date the 

stock appreciation right is exercised, 

with respect to a number of shares fixed 

on or before the date of grant of the 

right; 

(2) The stock appreciation right 

exercise price may never be less than 

the fair market value of the underlying 

stock (disregarding lapse restrictions as 

defined in § 1.83–3(i)) on the date the 

right is granted; and 

(3) The stock appreciation right does 

not include any feature for the deferral 

of compensation other than the deferral 

of recognition of income until the 

exercise of the stock appreciation right. 

(C) Stock rights that may provide for 

the deferral of compensation. An option 

to purchase stock other than service 

recipient stock, or a stock appreciation 

right with respect to stock other than 

service recipient stock, generally will 

provide for the deferral of compensation 

within the meaning of this paragraph 

(b). If under the terms of an option to 

purchase service recipient stock (other 

than an incentive stock option described 

in section 422 or a stock option granted 

under an employee stock purchase plan 

described in section 423), the amount 

required to purchase the stock is or 

could become less than the fair market 

value of the stock (disregarding lapse 

restrictions as defined in § 1.83–3(i)) on 

the date of grant, the grant of the option 

may provide for the deferral of 

compensation within the meaning of 

this paragraph (b). If under the terms of 

a stock appreciation right with respect 

to service recipient stock, the 

compensation payable under the stock 

appreciation right is or could be any 

amount greater than, with respect to a 

predetermined number of shares, the 

difference between the stock value 

(disregarding lapse restrictions as 

defined in § 1.83–3(i)) on the date of 

grant of the stock appreciation right and 

the stock value (disregarding lapse 

restrictions as defined in § 1.83–3(i)) on 

the date the stock appreciation right is 

exercised, the grant of the stock 

appreciation right may provide for a 

deferral of compensation within the 

meaning of this paragraph (b). 

(D) Feature for the deferral of 

compensation. To the extent a stock 

right grants the recipient a right other 

than to receive cash or stock on the date 

of exercise and such additional rights 

allow for the deferral of compensation, 

the entire arrangement (including the 

underlying stock right) provides for the 

deferral of compensation. For purposes 

of this paragraph (b)(5)(i), neither the 

right to receive substantially nonvested 

stock (as defined in § 1.83–3(b)) upon 

the exercise of a stock right, nor the 

right to pay the exercise price with 

previously acquired shares, constitutes a 

feature for the deferral of compensation. 

(E) Rights to dividends declared. For 

purposes of this paragraph (b)(5)(i), the 

right to receive, upon the exercise of a 

stock right, an amount equal to all or 

part of the dividends declared and paid 

on the number of shares underlying the 

stock right between the date of grant and 

the date of exercise of the stock right 

constitutes an offset to the exercise price 

of the stock option or an increase in the 

amount payable under the stock 

appreciation right (generally causing 

such stock rights to be subject to section 

409A), unless the right to the dividends 

declared and paid on the number of 

shares underlying the stock right is 

explicitly set forth as a separate 

arrangement. If set forth as a separate 

arrangement, the arrangement may 

provide for deferred compensation for 

purposes of section 409A. However, the 

existence of a separate arrangement to 

receive such an amount that complies 

with the requirements of section 409A 

would not cause a stock right to fail to 

satisfy the requirements of the exclusion 

from the definition of deferred 

compensation provided in paragraphs 

(b)(5)(i)(A) and (B) of this section. 

(ii) Statutory stock options. The grant 

of an incentive stock option as 

described in section 422, or the grant of 

an option under an employee stock 

purchase plan described in section 423 

(including the grant of an option with 

an exercise price discounted in 

accordance with section 423(b)(6) and 

the accompanying regulations), does not 

constitute a deferral of compensation. 

However, this paragraph (b)(5)(ii) does 

not apply to a modification, extension, 

or renewal of a statutory option that is 

treated as the grant of a new option that 

is not a statutory option. See § 1.424–

1(e). In such event, the option is treated 

as if it were a nonstatutory stock option 

at the date of the original grant, so that 

the modification, extension or renewal 

of the stock option that caused the stock 

option to be treated as the grant of a new 

option under § 1.424–1(e) is treated as 

causing the option to be treated as the 

grant of a new option for purposes of 

this paragraph (b)(5) only if such 

modification, extension or renewal of 

the stock option would have been 

treated as resulting in the grant of a new 

option under paragraph (b)(5)(v) of this 

section. 

(iii) Stock of the service recipient—(A) 

In general. Except as otherwise 

provided in paragraphs (b)(5)(iii)(B) and 

(C) of this section, for purposes of this 

section, stock of the service recipient 

means stock that, as of the date of grant, 

is common stock of a corporation that is 

a service recipient (including any 

member of a group of corporations or 

other entities treated as a single service 

recipient) that is readily tradable on an 

established securities market, or if none, 

that class of common stock of such 

corporation having the greatest 

aggregate value of common stock issued 

and outstanding of such corporation, or 

common stock with substantially 

similar rights to stock of such class 

(disregarding any difference in voting 

rights). However, under no 

circumstances does stock of the service 

recipient include stock that is preferred 

as to liquidation or dividend rights or 

that includes or is subject to a 

mandatory repurchase obligation or a 

put or call right that is not a lapse 

restriction as defined in § 1.83–3(i) and 

is based on a measure other than the fair 

market value (disregarding lapse 

restrictions as defined in § 1.83–3(i)) of 

the equity interest in the corporation 

represented by the stock. 

(B) American depositary receipts. For 

purposes of this section, an American 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57961 

depositary receipt or American 

depositary share may constitute service 

recipient stock, to the extent that the 

stock traded on a foreign securities 

market to which the American 

depositary receipt or American 

depositary share relates qualifies as 

service provider stock. 

(C) Mutual company units. For 

purposes of this section, mutual 

company units may constitute service 

recipient stock. For this purpose, the 

term mutual company unit means a 

fixed percentage of the overall value of 

a non-stock mutual company. For 

purposes of determining the value of the 

mutual company unit, the unit may be 

valued in accordance with the rules set 

forth in paragraph (b)(5)(iv)(B) of this 

section governing valuation of service 

recipient stock the shares of which are 

not traded on an established securities 

market, applied as if the mutual 

company were a stock corporation with 

one class of common stock and the 

number of shares of such stock 

determined according to the fixed 

percentage. For example, an 

appreciation right based on the 

appreciation of 10 mutual company 

units, where each unit is defined as 1 

percent of the overall value of the 

mutual company, would be valued as if 

the appreciation right were based upon 

10 shares of a corporation with 100 

shares of common stock and no other 

class of stock, whose shares are not 

readily tradable on an established 

securities market. 

(D) Definition of service recipient—(1) 

In general. For purposes of this 

paragraph (b)(5)(iii), the term service 

recipient generally has the same 

meaning as provided in paragraph (g) of 

this section, provided that a stock right, 

or the plan or arrangement under which 

the stock right is granted, may specify 

that in applying section 1563(a)(1), (2) 

and (3) for purposes of determining a 

controlled group of corporations under 

section 414(b), the language ‘‘at least 50 

percent’’ is used instead of ‘‘at least 80 

percent’’ each place it appears in section 

1563(a)(1), (2) and (3), and in applying 

§ 1.414(c)–2 for purposes of determining 

trades or businesses (whether or not 

incorporated) that are under common 

control for purposes of section 414(c), 

the language ‘‘at least 50 percent’’ is 

used instead of ‘‘at least 80 percent’’

each place it appears in § 1.414(c)–2. In 

addition, where the use of such stock 

with respect to the grant of a stock right 

to such service provider is based upon 

legitimate business criteria, the term 

service recipient has the same meaning 

as provided in paragraph (g) of this 

section, provided that the stock right, or 

the plan or arrangement under which 

the stock right is granted, may specify 

that in applying sections 1563(a)(1), (2) 

and (3) for purposes of determining a 

controlled group of corporations under 

section 414(b), the language ‘‘at least 20 

percent’’ is used instead of ‘‘at least 80 

percent’’ at each place it appears in 

sections 1563(a)(1), (2) and (3), and in 

applying § 1.414(c)–2 for purposes of 

determining trades or businesses 

(whether or not incorporated) that are 

under common control for purposes of 

section 414(c), the language ‘‘at least 20 

percent’’ is used instead of ‘‘at least 80 

percent’’ at each place it appears in 

§ 1.414(c)–2. For example, stock of a 

corporation participating in a joint 

venture involving an operating business, 

used with respect to stock rights granted 

to employees of the joint venture who 

are former employees of such 

corporation, generally will constitute 

use of such stock based upon legitimate 

business criteria, and therefore could 

constitute service provider stock with 

respect to such employees if the 

corporation owns at least 20 percent of 

the joint venture and the other 

requirements of this paragraph (b)(5)(iii) 

are met. A designation by a service 

recipient to use the 50 percent or 20 

percent thresholds described in this 

paragraph (b)(5)(iii)(D) must be applied 

consistently as to all compensatory 

stock rights for purposes of this 

paragraph (b)(5)(iii), and any 

designation of a different permissible 

ownership threshold percentage may 

not be made effective until 12 months 

after the adoption of such change. 

(2) Investment vehicles. 

Notwithstanding the provisions of 

paragraph (b)(5)(iii)(D)(1) of this section, 

except as to a service provider providing 

services directly to such corporation, for 

purposes of this paragraph (b)(5) the 

term service recipient does not include 

any corporation whose primary purpose 

is to serve as an investment vehicle with 

respect to the corporation’s interest in 

entities other than the service recipient. 

(3) Substitutions and assumptions by 

reason of a corporate transaction. If the 

requirements of paragraph (b)(5)(v)(D) of 

this section are met such that the 

substitution of a new stock right 

pursuant to a corporate transaction for 

an outstanding stock right, or the 

assumption of an outstanding stock 

right pursuant to a corporate 

transaction, would not be treated as the 

grant of a new stock right or a change 

in the form of payment for purposes of 

section 409A, the stock underlying the 

stock right that is substituted or 

assumed will be treated as service 

recipient stock for purposes of applying 

this paragraph (b)(5) to the replacement 

stock rights. For example, where by 

reason of a spinoff transaction under 

which a subsidiary corporation is spun 

off from a distributing corporation, a 

distributing corporation employee’s 

stock option to purchase distributing 

corporation stock is replaced with a 

stock option to purchase distributing 

corporation stock and a stock option to 

purchase the spun off subsidiary 

corporation’s stock, and where such 

substitution is not treated as a 

modification of the original stock option 

pursuant to paragraph (b)(5)(v)(D) of this 

section, both the distributing 

corporation stock and the subsidiary 

corporation stock are treated as service 

recipient stock for purposes of applying 

this paragraph (b)(5) to the replacement 

stock options. 

(E) Stock rights granted on or before 

December 31, 2004. Notwithstanding 

the requirements of paragraph 

(b)(5)(iii)(A) of this section, any class of 

common stock of the service recipient 

with respect to which stock rights were 

granted to service providers on or before 

December 31, 2004, is treated as service 

recipient stock for purposes of this 

paragraph (b)(5)(iii), but only with 

respect to stock rights granted on or 

before December 31, 2004. 

(iv) Determination of the fair market 

value of service recipient stock—(A) 

Stock readily tradable on an established 

securities market. For purposes of 

(b)(5)(i) of this section, in the case of 

service recipient stock that is readily 

tradable on an established securities 

market, the fair market value of the 

stock may be determined based upon 

the last sale before or the first sale after 

the grant, the closing price on the 

trading day before or the trading day of 

the grant, or any other reasonable basis 

using actual transactions in such stock 

as reported by such market and 

consistently applied. The determination 

of fair market value also may be based 

upon an average selling price during a 

specified period that is within 30 days 

before or 30 days after the grant, 

provided that the commitment to grant 

the stock right based on such valuation 

method must be irrevocable before the 

beginning of the specified period, and 

such valuation method must be used 

consistently for grants of stock rights 

under the same and substantially 

similar programs. 

(B) Stock not readily tradable on an 

established securities market—(1) In 

general. For purposes of paragraph 

(b)(5)(i) of this section, in the case of 

service recipient stock that is not readily 

tradable on an established securities 

market, the fair market value of the 

stock as of a valuation date means a 

value determined by the reasonable 

application of a reasonable valuation 

57962 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

method. The determination of whether 

a valuation method is reasonable, or 

whether an application of a valuation 

method is reasonable, is made based on 

the facts and circumstances as of the 

valuation date. Factors to be considered 

under a reasonable valuation method 

include, as applicable, the value of 

tangible and intangible assets of the 

corporation, the present value of future 

cash-flows of the corporation, the 

market value of stock or equity interests 

in similar corporations and other 

entities engaged in trades or businesses 

substantially similar to those engaged in 

by the corporation whose stock is to be 

valued, the value of which can be 

readily determined through objective 

means (such as through trading prices 

on an established securities market or 

an amount paid in an arm’s length 

private transaction), and other relevant 

factors such as control premiums or 

discounts for lack of marketability and 

whether the valuation method is used 

for other purposes that have a material 

economic effect on the service recipient, 

its stockholders or its creditors. The use 

of a valuation method is not reasonable 

if such valuation method does not take 

into consideration in applying its 

methodology, all available information 

material to the value of the corporation. 

Similarly, the use of a value previously 

calculated under a valuation method is 

not reasonable as of a later date if such 

calculation fails to reflect information 

available after the date of the calculation 

that may materially affect the value of 

the corporation (for example, the 

resolution of material litigation or the 

issuance of a patent) or the value was 

calculated with respect to a date that is 

more than 12 months earlier than the 

date for which the valuation is being 

used. The service recipient’s consistent 

use of a valuation method to determine 

the value of its stock or assets for other 

purposes, including for purposes 

unrelated to compensation of service 

providers, is also a factor supporting the 

reasonableness of such valuation 

method. 

(2) Presumption of reasonableness. 

For purposes of this paragraph 

(b)(5)(iv)(B), the consistent use of any of 

the following methods of valuation is 

presumed to result in a reasonable 

valuation, provided that the 

Commissioner may rebut such a 

presumption upon a showing that either 

the valuation method or the application 

of such method was grossly 

unreasonable: 

(i) A valuation of a class of stock 

determined by an independent appraisal 

that meets the requirements of section 

401(a)(28)(C) and the regulations 

thereunder as of a date that is no more 

than 12 months before the relevant 

transaction to which the valuation is 

applied (for example, the grant date of 

a stock option). 

(ii) A valuation based upon a formula 

that, if used as part of a nonlapse 

restriction (as defined in § 1.83–3(h)) 

with respect to the stock, would be 

considered to be the fair market value of 

the stock pursuant to § 1.83–5, provided 

that such stock is valued in the same 

manner for purposes of any nonlapse 

restriction applicable to the transfer of 

any shares of such class of stock (or 

substantially similar class of stock), and 

all noncompensatory purposes requiring 

the valuation of such stock, including 

regulatory filings, loan covenants, 

issuances to and repurchases of stock 

from persons other than service 

providers, and other third-party 

arrangements, and such valuation 

method is used consistently for all such 

purposes, and provided further that this 

paragraph (b)(5)(iv)(B)(2)(ii) does not 

apply with respect to stock subject to a 

stock right payable in stock, where the 

stock acquired pursuant to the exercise 

of the stock right is transferable other 

than through the operation of a 

nonlapse restriction. 

(iii) A valuation, made reasonably and 

in good faith and evidenced by a written 

report that takes into account the 

relevant factors described in paragraph 

(b)(5)(B)(iv)(1) of this section, of an 

illiquid stock of a start-up corporation. 

For this purpose, an illiquid stock of a 

start-up corporation is service recipient 

stock of a service recipient corporation 

that has no trade or business that it or 

any predecessor to it has conducted for 

a period of 10 years or more and has no 

class of equity securities that are traded 

on an established securities market (as 

defined in paragraph (k) of this section), 

where such stock is not subject to any 

put or call right or obligation of the 

service recipient or other person to 

purchase such stock (other than a right 

of first refusal upon an offer to purchase 

by a third party that is unrelated to the 

service recipient or service provider and 

other than a right or obligation that 

constitutes a lapse restriction as defined 

in § 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 

§ 1.409A–3(g)(5)(iv) or § 1.409A–

3(g)(5)(vi) or make a public offering of 

securities within the 12 months 

following the event to which the 

valuation is applied (for example, the 

grant of a stock option or exercise of a 

stock appreciation right). For purposes 

of this paragraph (b)(5)(iv)(B)(2)(iii), a 

valuation will not be treated as made 

reasonably and in good faith unless the 

valuation is performed by a person or 

persons with significant knowledge and 

experience or training in performing 

similar valuations. 

(3) Consistent use of a method. For 

purposes of paragraph (b)(5)(iv)(B)(2) of 

this section, the consistent use of a 

valuation method means the consistent 

use of the method for all equity-based 

compensation arrangements, including 

with respect to stock rights, for purposes 

of determining the exercise price, and 

with respect to stock appreciation rights 

not paid in stock, for purposes of 

determining the payment at the date of 

exercise, and for stock appreciation 

rights or stock options paid in stock 

subject to a put or call right providing 

for the potential repurchase by the 

service recipient, or other obligation of 

the service recipient or other person to 

purchase such stock, for purposes of 

determining the payment at the date of 

the purchase of such stock. 

Notwithstanding the foregoing, a service 

recipient may change the method 

prospectively for purposes of new grants 

of equity-based compensation, 

including stock rights. In addition, 

where after the date of grant, but before 

the date of exercise, of the stock right, 

the service provider stock to which the 

stock right relates becomes readily 

tradable on an established securities 

market, the service recipient must use 

the valuation method set forth in 

paragraph (b)(5)(iv)(A) of this section for 

purposes of determining the payment at 

the date of exercise or the purchase of 

the stock, as applicable. 

(v) Modifications, extensions, 

renewals, substitutions and assumptions 

of stock rights—(A) Treatment of 

modified stock right as a new grant. Any 

modification of the terms of a stock 

right, other than an extension or 

renewal of the stock right, is considered 

the granting of a new stock right. The 

new stock right may or may not 

constitute a deferral of compensation 

under paragraph (b)(5)(i) of this section, 

determined at the date of grant of the 

new stock right. Where a stock right is 

extended or renewed, the stock right is 

treated as having had an additional 

deferral feature from the date of grant. 

(B) Modification in general. The term 

modification means any change in the 

terms of the stock right (or change in the 

terms of the arrangement pursuant to 

which the stock right was granted or in 

the terms of any other agreement 

governing the stock right) that may 

provide the holder of the stock right 

with a direct or indirect reduction in the 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57963 

exercise price of the stock right, or an 

additional deferral feature, or an 

extension or renewal of the stock right, 

regardless of whether the holder in fact 

benefits from the change in terms. In 

contrast, a change in the terms of the 

stock right shortening the period during 

which the stock right is exercisable is 

not a modification. It is not a 

modification to add a feature providing 

the ability to tender previously acquired 

stock for the stock purchasable under 

the stock right, or to withhold or have 

withheld shares of stock to facilitate the 

payment of employment taxes or 

required withholding taxes resulting 

from the exercise of the stock right. In 

addition, it is not a modification for the 

grantor to exercise discretion 

specifically reserved under a stock right 

with respect to the transferability of the 

stock right. 

(C) Extensions and renewals. An 

extension of a stock right refers to the 

granting to the holder of an additional 

period of time within which to exercise 

the stock right beyond the time 

originally prescribed, provided that it is 

not an extension if the exercise period 

of the stock right is extended to a date 

no later than the later of the 15th day 

of the third month following the date at 

which, or December 31 of the calendar 

year in which, the stock right would 

otherwise have expired if the stock right 

had not been extended, based on the 

terms of the stock right at the original 

grant date. For example, an option 

granted January 1, 2011, that expires 

upon the earlier of January 1, 2021, or 

30 days after separation from service 

will not be considered to be modified if, 

upon the holder’s separation from 

service on July 1, 2015, the term is 

extended to December 31, 2015. 

Notwithstanding the foregoing, it is not 

an extension of a stock right if the 

expiration of the stock right is tolled 

while the stock right is unexercisable 

because an exercise of the stock right 

would violate applicable securities 

laws, provided that the period during 

which the stock right may be exercised 

is not extended more than 30 days after 

the exercise of the stock right first 

would no longer violate applicable 

securities laws. A renewal of a stock 

right is the granting by the corporation 

of the same rights or privileges 

contained in the original stock right on 

the same terms and conditions. 

(D) Substitutions and assumptions of 

stock rights by reason of a corporate 

transaction. If the requirements of 

§ 1.424–1 would be met if the stock right 

were a statutory option, the substitution 

of a new stock right pursuant to a 

corporate transaction for an outstanding 

stock right or the assumption of an 

outstanding stock right pursuant to a 

corporate transaction will not be treated 

as the grant of a new stock right or a 

change in the form of payment for 

purposes of section 409A. For purposes 

of the preceding sentence, the 

requirement of § 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 § 1.424–1(a)(5) may be 

satisfied by using market quotations for 

the stock of the distributing corporation 

and the stock distributed in the 

transaction as of a predetermined date 

not more than 60 days after the 

transaction or based on an average of 

such market prices over a 

predetermined period of not more than 

30 days ending not later than 60 days 

after the transaction. 

(E) Acceleration of date when 

exercisable. If a stock right is not 

immediately exercisable in full, a 

change in the terms of the right to 

accelerate the time at which the stock 

right (or any portion thereof) may be 

exercised is not a material modification 

for purposes of this section. With 

respect to a stock right subject to section 

409A, however, such an acceleration 

may constitute an impermissible 

acceleration of a payment date under 

§ 1.409A–3(c). Additionally, no 

modification occurs if a provision 

accelerating the time when a stock right 

may first be exercised is removed before 

the year in which it would otherwise be 

triggered. 

(F) Discretionary added benefits. If a 

change to a stock right provides, either 

by its terms or in substance, that the 

holder may receive an additional benefit 

under the stock right at the future 

discretion of the grantor, and the 

addition of such benefit would 

constitute a modification, then the 

addition of such discretion is a 

modification at the time that the stock 

right is changed to provide such 

discretion. 

(G) Change in underlying stock 

increasing value. A change in the terms 

of the stock subject to a stock right that 

increases the value of the stock is a 

modification of such stock right, except 

to the extent that a new stock right is 

substituted for such stock right by 

reason of the change in the terms of the 

stock in accordance with paragraph 

(b)(5)(v)(D) of this section. 

(H) Change in the number of shares 

purchasable. If a stock right is amended 

solely to increase the number of shares 

subject to the stock right, the increase is 

not considered a modification of the 

stock right but is treated as the grant of 

a new additional stock right to which 

the additional shares are subject. 

Notwithstanding the previous sentence, 

if the exercise price and number of 

shares subject to a stock right are 

proportionally adjusted to reflect a stock 

split (including a reverse stock split) or 

stock dividend, and the only effect of 

the stock split or stock dividend is to 

increase (or decrease) on a pro rata basis 

the number of shares owned by each 

shareholder of the class of stock subject 

to the stock right, then the stock right is 

not modified if it is proportionally 

adjusted to reflect the stock split or 

stock dividend and the aggregate 

exercise price of the stock right is not 

less than the aggregate exercise price 

before the stock split or stock dividend. 

(I) Rescission of changes. Any change 

to the terms of a stock right (or change 

in the terms of the plan pursuant to 

which the stock right was granted or in 

the terms of any other agreement 

governing the right) that would 

inadvertently result in treatment as a 

modification under paragraph 

(b)(5)(v)(A) of this section is not 

considered a modification of the stock 

right to the extent the change in the 

terms of the stock right is rescinded by 

the earlier of the date the stock right is 

exercised or the last day of the calendar 

year during which such change 

occurred. Thus, for example, if the 

terms of a stock right are changed on 

March 1 to extend the exercise period 

and the change is rescinded on 

November 1, then if the stock right is 

not exercised before the change is 

rescinded, the stock right is not 

considered modified under paragraph 

(b)(5)(v)(A) of this section. 

(J) Successive modifications. The 

rules of this paragraph (b)(5)(v) apply as 

well to successive modifications, 

including successive extensions or 

renewals. 

(6) Restricted Property—(i) In general. 

If a service provider receives property 

from, or pursuant to, a plan maintained 

by a service recipient, there is no 

deferral of compensation merely 

because the value of the property is not 

includible in income in the year of 

receipt by reason of the property being 

substantially nonvested (as defined in 

§ 1.83–3(b)), or is includible in income 

57964 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

solely due to a valid election under 

section 83(b). For purposes of this 

paragraph (b)(6)(i), a transfer of property 

includes the transfer of a beneficial 

interest in a trust or annuity plan, or a 

transfer to or from a trust or under an 

annuity plan, to the extent such a 

transfer is subject to section 83, section 

402(b) or section 403(c). 

(ii) Promises to transfer property. A 

plan under which a service provider 

obtains a legally binding right to receive 

property (whether or not the property 

will be substantially nonvested (as 

defined in § 1.83–3(b)) at the time of 

grant) in a future year may provide for 

the deferral of compensation and, 

accordingly, may constitute a 

nonqualified deferred compensation 

plan. The vesting of substantially 

nonvested property subject to section 83 

may be treated as a payment for 

purposes section 409A, including for 

purposes of applying the short-term 

deferral rules under paragraph (b)(4) of 

this section. Accordingly, where the 

promise to transfer the substantially 

nonvested property and the right to 

retain the substantially nonvested 

property are both subject to a substantial 

risk of forfeiture (as defined under 

paragraph (d) of this section), the 

arrangement generally would constitute 

a short-term deferral under paragraph 

(b)(4) of this section because the 

payment would occur simultaneously 

with the vesting of the right to the 

property. For example, where an 

employee participates in a two-year 

bonus program such that, if the 

employee continues in employment for 

two years, the employee is entitled to 

either the immediate payment of a 

$10,000 cash bonus or the grant of 

restricted stock with a $15,000 fair 

market value subject to a vesting 

requirement of three additional years of 

service, the arrangement generally 

would constitute a short-term deferral 

under paragraph (b)(4) of this section 

because under either alternative the 

payment would be received within the 

short-term deferral period. 

(7) Arrangements between 

partnerships and partners. [Reserved.] 

(8) Certain foreign arrangements—(i) 

Arrangements with respect to 

compensation covered by treaty or other 

international agreement. An 

arrangement with a service provider 

does not provide for a deferral of 

compensation for purposes of this 

paragraph (b) to the extent that the 

compensation under the arrangement 

would have been excluded from gross 

income for Federal income tax purposes 

under the provisions of any bilateral 

income tax convention or other bilateral 

or multilateral agreement to which the 

United States is a party if the 

compensation had been paid to the 

service provider at the time that the 

legally binding right to the 

compensation first arose or, if later, the 

time that the legally binding right was 

no longer subject to a substantial risk of 

forfeiture. 

(ii) Arrangements with respect to 

certain other compensation. An 

arrangement with a service provider 

does not provide for a deferral of 

compensation for purposes of this 

paragraph (b) to the extent that 

compensation under the arrangement 

would not have been includible in gross 

income for Federal tax purposes if it had 

been paid to the service provider at the 

time that the legally binding right to the 

compensation first arose or, if later, the 

time that the legally binding right was 

no longer subject to a substantial risk of 

forfeiture, due to one of the following—

(A) The service provider was a 

nonresident alien at such time and the 

compensation would not have been 

includible in gross income under 

section 872; 

(B) The service provider was a 

qualified individual (as defined in 

section 911(d)(1)) at such time and the 

compensation would have been foreign 

earned income within the meaning of 

section 911(b)(1) if paid at such time, 

the compensation would have been 

foreign earned income within the 

meaning of section 911(b)(1) that is less 

than the difference between the 

maximum exclusion amount under 

section 911(b)(2)(D) for such taxable 

year and the amount of foreign earned 

income actually excludible from gross 

income by such qualified individual for 

such taxable year under section 

911(a)(1); 

(C) The compensation would have 

been excludible from gross income 

under section 893; or 

(D) The compensation would have 

been excludible from gross income 

under section 931 or section 933. 

(iii) Tax equalization arrangements. 

Compensation paid under a tax 

equalization arrangement does not 

provide for a deferral of compensation, 

provided that any payment made under 

such arrangement is paid no later than 

the end of the second calendar year 

beginning after the calendar year in 

which the service provider’s U.S. 

Federal income tax return is required to 

be filed (including extension) for the 

year to which the tax equalization 

payment relates. For purposes of this 

paragraph (b)(8)(iii), the term tax 

equalization arrangement refers to an 

arrangement that provides payments 

intended to compensate the service 

provider for the excess of the taxes 

actually imposed by a foreign 

jurisdiction on the compensation paid 

(other than the compensation under the 

tax equalization agreement) by the 

service recipient to the service provider 

over the taxes that would be imposed if 

the compensation were subject solely to 

United States Federal income tax, and 

provided that the payments made under 

such arrangement may not exceed such 

excess and the amount necessary to 

compensate for the additional taxes on 

the amounts paid under the 

arrangement. 

(iv) Additional foreign arrangements. 

An arrangement with a service provider 

does not provide for a deferral of 

compensation for purposes of this 

paragraph (b) to the extent designated 

by the Commissioner in revenue 

procedures, notices, or other guidance 

published in the Internal Revenue 

Bulletin (see § 601.601(d)(2) of this 

chapter). 

(v) Earnings. Earnings on 

compensation excluded from the 

definition of deferral of compensation 

pursuant to this paragraph (b)(8) are also 

not treated as a deferred compensation. 

However, amounts that would be 

recharacterized as deferred 

compensation under § 31.3121(v)(2)–

1(d)(2)(iii)(B) of this chapter 

(nonaccount balance plans), 

§ 31.3121(v)(2)–1(d)(2)(iii)(A) of this 

chapter (account balance plans), or 

similar principles with respect to plans 

that are neither nonaccount balance 

plans nor account balance plans, will 

not be treated as earnings for purposes 

of this paragraph (b)(8)(v). 

(9) Separation pay arrangements—(i) 

In general. An arrangement that 

otherwise provides for a deferral of 

compensation under this paragraph (b) 

does not fail to provide a deferral of 

compensation merely because the right 

to payment of the compensation is 

conditioned upon a separation from 

service. However, see paragraphs 

(b)(9)(ii), (iii) and (iv) of this section for 

separation pay arrangements that do not 

provide for the deferral of 

compensation. Notwithstanding any 

other provision of this paragraph (b)(9), 

any payment or benefit, or entitlement 

to a payment or benefit, that acts as a 

substitute for, or replacement of, 

amounts deferred by the service 

recipient under a separate nonqualified 

deferred compensation plan constitutes 

a payment or a deferral of compensation 

under the separate nonqualified 

deferred compensation plan, and does 

not constitute a payment or deferral of 

compensation under a separation pay 

arrangement. 

(ii) Collectively bargained separation 

pay arrangements. A separation pay 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57965 

arrangement does not provide for a 

deferral of compensation if the 

arrangement is a collectively bargained 

separation pay arrangement that 

provides for separation pay upon an 

actual involuntary separation from 

service or pursuant to a window 

program. Only the portion of the 

separation pay arrangement attributable 

to employees covered by a collective 

bargaining agreement is considered to 

be provided under a collectively 

bargained separation pay arrangement. 

A collectively bargained separation pay 

arrangement is a separation pay 

arrangement that meets the following 

conditions: 

(A) The separation pay arrangement is 

contained within an agreement that the 

Secretary of Labor determines to be a 

collective bargaining agreement. 

(B) The separation pay provided by 

the collective bargaining agreement was 

the subject of arms-length negotiations 

between employee representatives and 

one or more employers, and the 

agreement between employee 

representatives and one or more 

employers satisfies section 7701(a)(46). 

(C) The circumstances surrounding 

the agreement evidence good faith 

bargaining between adverse parties over 

the separation pay to be provided under 

the agreement. 

(iii) Separation pay plans due to 

involuntary separation from service or 

participation in a window program. A 

separation pay plan that is not described 

in paragraph (b)(9)(ii) of this section and 

that provides for separation pay upon an 

actual involuntary separation from 

service or pursuant to a window 

program does not provide for a deferral 

of compensation if the plan provides 

that—

(A) The separation pay (other than 

amounts described in paragraph 

(b)(9)(iv) of this section) may not exceed 

two times the lesser of—

(1) The sum of the service provider’s 

annual compensation (as defined in 

§ 1.415–1(d)(2)) for services provided to 

the service recipient as an employee and 

the service provider’s net earnings from 

self-employment (as defined in section 

1402(a)(1)) for services provided to the 

service recipient as an independent 

contractor, each for the calendar year 

preceding the calendar year in which 

the service provider has a separation 

from service from such service 

recipient; or 

(2) The maximum amount that may be 

taken into account under a qualified 

plan pursuant to section 401(a)(17) for 

such year; and 

(B) The separation pay must be paid 

no later than December 31 of the second 

calendar year following the calendar 

year in which occurs the separation 

from service. 

(iv) Reimbursements and certain other 

separation payments—(A) In general. 

To the extent a separation pay 

arrangement entitles a service provider 

to payment by the service recipient for 

a limited period of time of 

reimbursements that are otherwise 

excludible from gross income, of 

reimbursements for expenses that the 

service provider can deduct under 

section 162 or section 167 as business 

expenses incurred in connection with 

the performance of services (ignoring 

any applicable limitation based on 

adjusted gross income), or of reasonable 

outplacement expenses and reasonable 

moving expenses actually incurred by 

the service provider and directly related 

to the termination of services for the 

service recipient, such arrangement 

does not provide for a deferral of 

compensation. To the extent a 

separation pay arrangement (including 

an arrangement involving payments due 

to a voluntary separation from service) 

entitles a service provider to 

reimbursement by the service recipient 

for a limited period of time of payments 

of medical expenses incurred and paid 

by the service provider but not 

reimbursed and allowable as a 

deduction under section 213 

(disregarding the requirement of section 

213(a) that the deduction is available 

only to the extent that such expenses 

exceed 7.5 percent of adjusted gross 

income), such arrangement does not 

provide for a deferral of compensation. 

(B) In-kind benefits and direct service 

recipient payments. A service provider’s 

entitlement to in-kind benefits from the 

service recipient, or a payment by the 

service recipient directly to the person 

providing the goods or services to the 

service provider, will also be treated as 

not providing for a deferral of 

compensation for purposes of this 

paragraph (b), if a right to 

reimbursement by the service recipient 

for a payment for such benefits, goods 

or services by the service provider 

would not be treated as providing for a 

deferral of compensation under this 

paragraph (b)(9)(iv). 

(C) De minimis payments. In addition, 

if not otherwise excluded, to the extent 

a separation pay arrangement entitles a 

service provider to reimbursements or 

other payments or benefits that do not 

exceed $5,000 in the aggregate, such 

arrangement does not provide for a 

deferral of compensation. 

(D) Limited period of time. For 

purposes of paragraphs (b)(9)(iv)(A) and 

(B), a limited period of time refers to 

both the period during which applicable 

expenses may be incurred, and the 

period during which reimbursements 

must be paid, and may not extend 

beyond the December 31 of the second 

calendar year following the calendar 

year in which the separation from 

service occurred. 

(v) Window programs—definition. 

The term window program refers to a 

program established by the service 

recipient to provide for separation pay 

in connection with a separation from 

service, for a limited period of time (no 

greater than one year), to service 

providers who separate from service 

during that period or to service 

providers who separate from service 

during that period under specified 

circumstances. A program will not be 

considered a window program if a 

service recipient establishes a pattern of 

repeatedly providing for similar 

separation pay in similar situations for 

substantially consecutive, limited 

periods of time. Whether the recurrence 

of these programs constitutes a pattern 

is determined based on the facts and 

circumstances. Although no one factor 

is determinative, relevant factors 

include whether the benefits are on 

account of a specific business event or 

condition, the degree to which the 

separation pay relates to the event or 

condition, and whether the event or 

condition is temporary or discrete or is 

a permanent aspect of the employer’s 

business. 

(c) Plan—(1) In general. The term 

plan includes any agreement, method or 

arrangement, including an agreement, 

method or arrangement that applies to 

one person or individual. A plan may be 

adopted unilaterally by the service 

recipient or may be negotiated or agreed 

to by the service recipient and one or 

more service providers or service 

provider representatives. An agreement, 

method or arrangement may constitute a 

plan regardless of whether it is an 

employee benefit plan under section 

3(3) of the Employee Retirement Income 

Security Act of 1974 (ERISA), as 

amended (29 U.S.C. 1002(3)). The 

requirements of section 409A are 

applied as if a separate plan or plans is 

maintained for each service provider. 

(2) Plan aggregation rules—(i) In 

general. Except as provided in 

paragraph (c)(2)(ii) of this section, with 

respect to arrangements between a 

service provider and a service 

recipient—

(A) All amounts deferred with respect 

to that service provider under all 

account balance plans of the service 

recipient (as defined in § 31.3121(v)(2)–

1(c)(1)(ii)(A) of this chapter) other than 

a separation pay arrangement described 

in paragraph (c)(2)(i)(C) of this section 

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are treated as deferred under a single 

plan; 

(B) All amounts deferred with respect 

to that service provider under all 

nonaccount balance plans of the service 

recipient (as defined in § 31.3121(v)(2)–

1(c)(2)(i) of this chapter) other than a 

separation pay arrangement described in 

paragraph (c)(2)(i)(C) of this section are 

treated as deferred under a separate 

single plan; 

(C) All amounts deferred with respect 

to that service provider under all 

separation pay arrangements (as defined 

in paragraph (m) of this section) of the 

service recipient due to an involuntary 

termination or participation in a 

window program are treated as deferred 

under a single plan; and 

(D) All amounts deferred with respect 

to that service provider under all plans 

of the service recipient that are not 

described in paragraph (c)(2)(i)(A), (B) 

or (C) of this section (for example, 

discounted stock options, stock 

appreciation rights or other equity-based 

compensation described in 

§ 31.3121(v)(2)–1(b)(4)(ii) of this 

chapter) are treated as deferred under a 

separate single plan. 

(ii) Dual status. Arrangements in 

which a service provider participates 

are not aggregated to the extent the 

service provider participates in one set 

of arrangements due to status as an 

employee of the service recipient 

(employee arrangements) and another 

set of arrangements due to status as an 

independent contractor of the service 

recipient (independent contractor 

arrangements). For example, where a 

service provider deferred amounts 

under an arrangement while providing 

services as an independent contractor, 

and then becomes eligible for and defers 

amounts under a separate arrangement 

after being hired as an employee, the 

two arrangements will not be aggregated 

for purposes of this paragraph (c)(2). 

Where an employee also serves as a 

director of the service recipient (or a 

similar position with respect to a noncorporate service recipient), the 

arrangements under which the 

employee participates as a director of 

the service recipient (director 

arrangements) are not aggregated with 

employee arrangements, provided that 

the director arrangements are 

substantially similar to arrangements 

provided to service providers providing 

services only as directors (or similar 

positions with respect to non-corporate 

service recipients). For example, an 

employee director who participates in 

an employee arrangement and a director 

arrangement generally may treat the two 

arrangements as separate plans, 

provided that the director arrangement 

is substantially similar to an 

arrangement providing benefits to a 

non-employee director. Director 

arrangements and independent 

contractor arrangements are aggregated 

for purposes of this paragraph (c)(2). 

(3) Establishment of arrangement—(i) 

In general. To satisfy the requirements 

of section 409A, an arrangement must 

be established and maintained by a 

service recipient, in both form and 

operation, in accordance with the 

requirements of section 409A and these 

regulations. For purposes of this 

paragraph (c)(3), an arrangement is 

established on the latest of the date on 

which it is adopted, the date on which 

it is effective, and the date on which the 

material terms of the plan are set forth 

in writing. For purposes of this 

paragraph (c)(3)(i), an arrangement will 

be deemed to be set forth in writing if 

it is set forth in any other form that is 

approved by the Commissioner. The 

material terms of the arrangement 

include the amount (or the method or 

formula for determining the amount) of 

deferred compensation to be provided 

under the arrangement and the time 

when it will be paid. Notwithstanding 

the foregoing, an arrangement will be 

deemed to be established as of the date 

the participant obtains a legally binding 

right to deferred compensation, 

provided that the arrangement is 

otherwise established under the rules of 

this paragraph (c)(3)(i) by the end of the 

calendar year in which the legally 

binding right arises, or with respect to 

an amount not payable in the year 

immediately following the year in 

which the legally binding right arises 

(the subsequent year), the 15th day of 

the third month of the subsequent year. 

(ii) Amendments to the arrangement. 

In the case of an amendment that 

increases the amount deferred under an 

arrangement providing for the deferral 

of compensation, the arrangement is not 

considered established with respect to 

the additional amount deferred until the 

arrangement, as amended, is established 

in accordance with paragraph (c)(3)(i) of 

this section. 

(iii) Transition rule for written plan 

requirement. For purposes of this 

section, an unwritten arrangement that 

was adopted and effective before 

December 31, 2006, is treated as 

established under this section as of the 

later of the date on which it was 

adopted or became effective, provided 

that the material terms of the 

arrangement are set forth in writing on 

or before December 31, 2006. 

(iv) Plan aggregation rules. The plan 

aggregation rules of paragraph (c)(2)(i) of 

this section do not apply to the 

requirements of paragraphs (c)(3)(i) and 

(ii) of this section. Accordingly, an 

arrangement that fails to meet the 

requirements of section 409A solely due 

to a failure to meet the requirements of 

paragraph (c)(3)(i) or (ii) is not 

aggregated with other arrangements that 

meet such requirements. 

(d) Substantial risk of forfeiture—(1) 

In general. Compensation is subject to a 

substantial risk of forfeiture if 

entitlement to the amount is 

conditioned on the performance of 

substantial future services by any 

person or the occurrence of a condition 

related to a purpose of the 

compensation, and the possibility of 

forfeiture is substantial. For purposes of 

this paragraph (d), a condition related to 

a purpose of the compensation must 

relate to the service provider’s 

performance for the service recipient or 

the service recipient’s business 

activities or organizational goals (for 

example, the attainment of a prescribed 

level of earnings, equity value or an 

initial public offering). Any addition of 

a substantial risk of forfeiture after the 

legally binding right to the 

compensation arises, or any extension of 

a period during which compensation is 

subject to a substantial risk of forfeiture, 

in either case whether elected by the 

service provider, service recipient or 

other person (or by agreement of two or 

more of such persons), is disregarded for 

purposes of determining whether such 

compensation is subject to a substantial 

risk of forfeiture. An amount is not 

subject to a substantial risk of forfeiture 

merely because the right to the amount 

is conditioned, directly or indirectly, 

upon the refraining from performance of 

services. For purposes of section 409A, 

an amount will not be considered 

subject to a substantial risk of forfeiture 

beyond the date or time at which the 

recipient otherwise could have elected 

to receive the amount of compensation, 

unless the amount subject to a 

substantial risk of forfeiture (ignoring 

earnings) is materially greater than the 

amount the recipient otherwise could 

have elected to receive. For example, a 

salary deferral generally may not be 

made subject to a substantial risk of 

forfeiture. But, for example, where a 

bonus arrangement provides an election 

between a cash payment of a certain 

amount or restricted stock units with a 

materially greater value that will be 

forfeited absent continued services for a 

period of years, the right to the 

restricted stock units generally will be 

treated as subject to a substantial risk of 

forfeiture. 

(2) Stock rights. A stock right will be 

treated as not subject to a substantial 

risk of forfeiture at the earlier of the first 

date the holder may exercise the stock 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57967 

right and receive cash or property that 

is substantially vested (as defined in 

§ 1.83–3(b)) or the first date that the 

stock right is not subject to a forfeiture 

condition that would constitute a 

substantial risk of forfeiture. 

Accordingly, a stock option that the 

service provider may exercise 

immediately and receive substantially 

vested stock will be treated as not 

subject to a substantial risk of forfeiture, 

even if the stock option automatically 

terminates upon the service provider’s 

separation from service. 

(3) Enforcement of forfeiture 

condition—(i) In general. In determining 

whether the possibility of forfeiture is 

substantial in the case of rights to 

compensation granted by a service 

recipient to a service provider that owns 

a significant amount of the total 

combined voting power or value of all 

classes of equity of the service recipient 

or of its parent, all relevant facts and 

circumstances will be taken into 

account in determining whether the 

probability of the service recipient 

enforcing such condition is substantial, 

including—

(A) The service provider’s 

relationship to other equity holders and 

the extent of their control, potential 

control and possible loss of control of 

the service recipient; 

(B) The position of the service 

provider in the service recipient and the 

extent to which the service provider is 

subordinate to other service providers; 

(C) The service provider’s relationship 

to the officers and directors of the 

service recipient (or similar positions 

with respect to a noncorporate service 

recipient); 

(D) The person or persons who must 

approve the service provider’s 

discharge; and 

(E) Past actions of the service 

recipient in enforcing the restrictions. 

(ii) Examples. The following 

examples illustrate the rules of 

paragraph (d)(3)(i) of this section: 

Example 1. A service provider would be 

considered as having deferred compensation 

subject to a substantial risk of forfeiture, but 

for the fact that the service provider owns 20 

percent of the single class of stock in the 

transferor corporation. If the remaining 80 

percent of the class of stock is owned by an 

unrelated individual (or members of such an 

individual’s family) so that the possibility of 

the corporation enforcing a restriction on 

such rights is substantial, then such rights are 

subject to a substantial risk of forfeiture. 

Example 2. A service provider would be 

considered as having deferred compensation 

subject to a substantial risk of forfeiture, but 

for the fact that the service provider who is 

president of the corporation, also owns 4 

percent of the voting power of all the stock 

of a corporation. If the remaining stock is so 

diversely held by the public that the 

president, in effect, controls the corporation, 

then the possibility of the corporation 

enforcing a restriction on the right to deferred 

compensation of the president is not 

substantial, and such rights are not subject to 

a substantial risk of forfeiture. 

(e) Performance-based 

compensation—(1) In general. The term 

performance-based compensation 

means compensation where the amount 

of, or entitlement to, the compensation 

is contingent on the satisfaction of 

preestablished organizational or 

individual performance criteria relating 

to a performance period of at least 12 

consecutive months in which the 

service provider performs services. 

Organizational or individual 

performance criteria are considered 

preestablished if established in writing 

by not later than 90 days after the 

commencement of the period of service 

to which the criteria relates, provided 

that the outcome is substantially 

uncertain at the time the criteria are 

established. Performance-based 

compensation may include payments 

based on performance criteria that are 

not approved by a compensation 

committee of the board of directors (or 

similar entity in the case of a noncorporate service recipient) or by the 

stockholders or members of the service 

recipient. Notwithstanding the 

foregoing, performance-based 

compensation does not include any 

amount or portion of any amount that 

will be paid either regardless of 

performance, or based upon a level of 

performance that is substantially certain 

to be met at the time the criteria is 

established. Except as provided in 

paragraph (e)(3) of this section, 

compensation is not performance-based 

compensation merely because the 

amount of such compensation is based 

on the value of, or increase in the value 

of, the service recipient or the stock of 

the service recipient. 

(2) Payments based upon subjective 

performance criteria. The term 

performance-based compensation may 

include payments based upon subjective 

performance criteria, provided that—

(i) The subjective performance criteria 

relate to the performance of the 

participant service provider, a group of 

service providers that includes the 

participant service provider, or a 

business unit for which the participant 

service provider provides services 

(which may include the entire 

organization); and 

(ii) The determination that any 

subjective performance criteria have 

been met is not made by the participant 

service provider or a family member of 

the participant service provider (as 

defined in section 267(c)(4) applied as 

if the family of an individual includes 

the spouse of any member of the 

family), or a person under the 

supervision of the participant service 

provider or such a family member, or 

where any amount of the compensation 

of the person making such 

determination is controlled in whole or 

in part by the service provider or such 

a family member. 

(3) Equity-based compensation. 

Compensation is performance-based 

compensation if it is based solely on an 

increase in the value of the service 

recipient, or stock of the service 

recipient, after the date of a grant or 

award. If the amount of compensation 

the service provider will receive under 

a grant or award is not based solely on 

an increase in the value of the service 

recipient, or stock of the service 

recipient, after the date of the grant or 

award (for example, a stock appreciation 

right granted with an exercise price that 

is less than the fair market value of the 

stock as of the date of grant), and that 

other amount would not otherwise 

qualify as performance-based 

compensation, the compensation 

attributable to the grant or award does 

not qualify as performance-based 

compensation. Notwithstanding the 

foregoing, an award of equity-based 

compensation may constitute 

performance-based compensation if 

entitlement to the compensation is 

subject to a condition that would cause 

the award to otherwise qualify as 

performance-based compensation, such 

as a performance-based vesting 

condition. The eligibility to defer 

compensation under an equity-based 

compensation award constitutes an 

additional deferral feature with respect 

to the award for purposes of the 

definition of a deferral of compensation 

under paragraph (b)(5) of this section. 

(f) Service provider—(1) In general. 

The term service provider includes—

(i) An individual, corporation, 

subchapter S corporation or partnership; 

(ii) A personal service corporation (as 

defined in section 269A(b)(1)), or a 

noncorporate entity that would be a 

personal service corporation if it were a 

corporation; or 

(iii) A qualified personal service 

corporation (as defined in section 

448(d)(2)), or a noncorporate entity that 

would be a qualified personal service 

corporation if it were a corporation. 

(2) Service providers using an accrual 

method of accounting. Section 409A 

does not apply to a deferral under an 

arrangement between taxpayers if, for 

the taxable year in which the service 

provider taxpayer obtains a legally 

binding right to the compensation, the 

57968 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

service provider uses an accrual method 

of accounting for Federal tax purposes. 

(3) Independent contractors—(i) In 

general. Except as otherwise provided 

in paragraph (f)(3)(iv) of this section, 

section 409A does not apply to an 

amount deferred under an arrangement 

between a service provider and service 

recipient with respect to a particular 

trade or business in which the service 

provider participates, if during the 

service provider’s taxable year in which 

the service provider obtains a legally 

binding right to the payment of the 

amount deferred—

(A) The service provider is actively 

engaged in the trade or business of 

providing services, other than as an 

employee or as a director of a 

corporation; 

(B) The service provider provides 

significant services to two or more 

service recipients to which the service 

provider is not related and that are not 

related to one another (as defined in 

paragraph (f)(3)(ii) of this section); and 

(C) The service provider is not related 

to the service recipient, applying the 

definition of related person contained in 

paragraph (f)(3)(ii) of this section subject 

to the modification that the language 

‘‘50 percent’’ is used instead of ‘‘20 

percent’’ each place it appears in 

sections 267(b)(1) and 707(b)(1). 

(ii) Related person. For purposes of 

this paragraph (f)(3), a person is related 

to another person if the persons bear a 

relationship to each other that is 

specified in section 267(b) or 707(b)(1), 

subject to the modifications that the 

language ‘‘20 percent’’ is used instead of 

‘‘50 percent’’ each place it appears in 

sections 267(b) and 707(b)(1), and 

section 267(c)(4) is applied as if the 

family of an individual includes the 

spouse of any member of the family; or 

the persons are engaged in trades or 

businesses under common control 

(within the meaning of section 52(a) and 

(b)). In addition, an individual is related 

to an entity if the individual is an officer 

of an entity that is a corporation, or 

holds a position substantially similar to 

an officer of a corporation with an entity 

that is not a corporation. 

(iii) Significant services. Whether a 

service provider is providing significant 

services depends on the facts and 

circumstances of each case. However, 

for purposes of paragraph (f)(3)(i) of this 

section, a service provider who provides 

services to two or more service 

recipients to which the service provider 

is not related and that are not related to 

one another is deemed to be providing 

significant services to two or more of 

such service recipients for a given 

taxable year, if the revenues generated 

from the services provided to any 

service recipient or group of related 

service recipients during such taxable 

year do not exceed 70 percent of the 

total revenue generated by the service 

provider from the trade or business of 

providing such services. 

(iv) Management services. A service 

provider is treated as related to a service 

recipient for purposes of paragraph 

(f)(3)(i) of this section if the service 

provider provides management services 

to the service recipient. For purposes of 

this paragraph (f)(3)(iv), the term 

management services means services 

that involve the actual or de facto 

direction or control of the financial or 

operational aspects of a trade or 

business of the service recipient, or 

investment advisory services provided 

to a service recipient whose primary 

trade or business includes the 

management of financial assets 

(including investments in real estate) for 

its own account, such as a hedge fund 

or a real estate investment trust. 

(g) Service recipient. Except as 

otherwise specifically provided in these 

regulations, the term service recipient 

means the person for whom the services 

are performed and with respect to 

whom the legally binding right to 

compensation arises, and all persons 

with whom such person would be 

considered a single employer under 

section 414(b) (employees of controlled 

group of corporations), and all persons 

with whom such person would be 

considered a single employer under 

section 414(c) (employees of 

partnerships, proprietorships, etc., 

under common control). For example, 

where the service provider is an 

employee, the service recipient 

generally is the employer. 

Notwithstanding the foregoing, section 

409A applies to a plan that provides for 

the deferral of compensation, even 

though the payment of the 

compensation is not made by the person 

for whom services are performed. 

(h) Separation from service—(1) 

Employees—(i) In general. An employee 

separates from service with the service 

recipient if the employee dies, retires, or 

otherwise has a termination of 

employment with the employer. 

However, for purposes of this paragraph 

(h)(1), the employment relationship is 

treated as continuing intact while the 

individual is on military leave, sick 

leave, or other bona fide leave of 

absence (such as temporary employment 

by the government) if the period of such 

leave does not exceed six months, or if 

longer, so long as the individual’s right 

to reemployment with the service 

recipient is provided either by statute or 

by contract. If the period of leave 

exceeds six months and the individual’s 

right to reemployment is not provided 

either by statute or by contract, the 

employment relationship is deemed to 

terminate on the first date immediately 

following such six-month period. 

(ii) Termination of employment. 

Whether a termination of employment 

has occurred is determined based on the 

facts and circumstances. Where an 

employee either actually or purportedly 

continues in the capacity as an 

employee, such as through the 

execution of an employment agreement 

under which the employee agrees to be 

available to perform services if 

requested, but the facts and 

circumstances indicate that the 

employer and the employee did not 

intend for the employee to provide more 

than insignificant services for the 

employer, an employee will be treated 

as having a separation from service for 

purposes of this paragraph (h)(1). For 

purposes of the preceding sentence, an 

employer and employee will not be 

treated as having intended for the 

employee to provide insignificant 

services where the employee continues 

to provide services as an employee at an 

annual rate that is at least equal to 20 

percent of the services rendered, on 

average, during the immediately 

preceding three full calendar years of 

employment (or, if employed less than 

three years, such lesser period) and the 

annual remuneration for such services is 

at least equal to 20 percent of the 

average annual remuneration earned 

during the final three full calendar years 

of employment (or, if less, such lesser 

period). Where an employee continues 

to provide services to a previous 

employer in a capacity other than as an 

employee, a separation from service will 

not be deemed to have occurred for 

purposes of this paragraph (h)(1) if the 

former employee is providing services at 

an annual rate that is 50 percent or more 

of the services rendered, on average, 

during the immediately preceding three 

full calendar years of employment (or if 

employed less than three years, such 

lesser period) and the annual 

remuneration for such services is 50 

percent or more of the annual 

remuneration earned during the final 

three full calendar years of employment 

(or if less, such lesser period). For 

purposes of this paragraph (h)(1)(ii), the 

annual rate of providing services is 

determined based upon the 

measurement used to determine the 

service provider’s base compensation 

(for example, amounts of time required 

to earn salary, hourly wages, or 

payments for specific projects). 

(2) Independent contractors—(i) In 

general. An independent contractor is 

considered to have a separation from 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57969 

service with the service recipient upon 

the expiration of the contract (or in the 

case of more than one contract, all 

contracts) under which services are 

performed for the service recipient if the 

expiration constitutes a good-faith and 

complete termination of the contractual 

relationship. An expiration does not 

constitute a good faith and complete 

termination of the contractual 

relationship if the service recipient 

anticipates a renewal of a contractual 

relationship or the independent 

contractor becoming an employee. For 

this purpose, a service recipient is 

considered to anticipate the renewal of 

the contractual relationship with an 

independent contractor if it intends to 

contract again for the services provided 

under the expired contract, and neither 

the service recipient nor the 

independent contractor has eliminated 

the independent contractor as a possible 

provider of services under any such new 

contract. Further, a service recipient is 

considered to intend to contract again 

for the services provided under an 

expired contract if the service 

recipient’s doing so is conditioned only 

upon incurring a need for the services, 

the availability of funds, or both. 

(ii) Special rule. Notwithstanding 

paragraph (b)(2) of this section, the plan 

is considered to satisfy the requirement 

described in paragraph (a) of this 

section that no amounts deferred under 

the plan be paid or made available to 

the participant before the participant 

has a separation from service with the 

service recipient if, with respect to 

amounts payable to a participant who is 

an independent contractor, a plan 

provides that—

(A) No amount will be paid to the 

participant before a date at least 12 

months after the day on which the 

contract expires under which services 

are performed for the service recipient 

(or, in the case of more than one 

contract, all such contracts expire); and 

(B) No amount payable to the 

participant on that date will be paid to 

the participant if, after the expiration of 

the contract (or contracts) and before 

that date, the participant performs 

services for the service recipient as an 

independent contractor or an employee. 

(i) Specified employee—(1) In general. 

The term specified employee means a 

key employee (as defined in section 

416(i) without regard to section 

416(i)(5)) of a service recipient any stock 

of which is publicly traded on an 

established securities market or 

otherwise. For purposes of this 

paragraph (i)(1), an employee is a key 

employee if the employee meets the 

requirements of section 416(i)(1)(A)(i), 

(ii) or (iii) (applied in accordance with 

the regulations thereunder and 

disregarding section 416(i)(5)) at any 

time during the 12-month period ending 

on an identification date. If a person is 

a key employee as of an identification 

date, the person is treated as a specified 

employee for the 12-month period 

beginning on the first day of the fourth 

month following the identification date. 

A service recipient may designate any 

date in a calendar year as the 

identification date provided that a 

service recipient must use the same 

identification date with respect to all 

arrangements, and any change to the 

identification date may not be effective 

for a period of 12 months. If no 

identification date is designated, the 

identification date is December 31. The 

service recipient may designate an 

identification date through inclusion in 

each plan document or through a 

separate document, provided that the 

service recipient will not be treated as 

having designated an identification date 

on any date before the execution of the 

document containing the designation. 

Notwithstanding the foregoing, any 

designation of an identification date 

made on or before December 31, 2006, 

may be applied to any separation from 

service occurring on or after January 1, 

2005. Whether any stock of a service 

recipient is publicly traded on an 

established securities market or 

otherwise must be determined as of the 

date of the employee’s separation from 

service. 

(2) Spinoffs and mergers. Where a 

new corporation or entity (new 

corporation) is established as part of a 

corporate division governed by section 

355 from a corporation that is publicly 

traded on an established securities 

market or otherwise (old corporation), 

any employee of the new corporation 

who was a key employee of the old 

corporation immediately prior to the 

spinoff is a key employee of the new 

corporation until the end of the 12- 

month period beginning on the first day 

of the fourth month following the old 

corporation’s last identification date 

preceding the spinoff transaction. 

Where two corporations (pre-merger 

corporations) are merged or become part 

of the same controlled group of 

corporations so as to be treated as a 

single service recipient under paragraph 

(g) of this section, any employee of the 

merged corporation who was a key 

employee of either of the pre-merger 

corporations immediately before the 

merger is a key employee of the merged 

corporation until the first day of the 

fourth month after the identification 

date of the merged corporation next 

following the merger. 

(3) Nonresident alien employees. For 

purposes of determining key employees, 

a service recipient generally must 

include all employees, including 

employees who are nonresident aliens. 

However, a plan may provide without 

causing an amount to be treated as an 

additional deferral as to any affected 

participant that for purposes of applying 

the six-month delay to specified 

employees, all employees that are 

nonresident aliens during the entire 12- 

month period ending with the relevant 

identification date are excluded for 

purposes of determining which 

employees meet the requirements of 

section 416(i)(1)(A)(i), (ii) or (iii) 

(applied in accordance with the 

regulations thereunder and disregarding 

section 416(i)(5)); provided that a 

service recipient must apply such 

exclusion with respect to all 

arrangements of the service recipient, 

and any change to include such 

nonresident alien employees may not be 

effective for a period of 12 months. 

(j) Nonresident alien—(1) Except as 

provided in paragraph (j)(2) of this 

section, for purposes of this section the 

term nonresident alien means an 

individual who is—

(i) A nonresident alien within the 

meaning of section 7701(b)(1)(B); or 

(ii) A dual resident taxpayer within 

the meaning of § 301.7701(b)–7(a)(1) of 

this chapter with respect to any taxable 

year in which such individual is treated 

as a nonresident alien for purposes of 

computing the individual’s U.S. income 

tax liability. 

(2) The term nonresident alien does 

not include—

(i) A nonresident alien with respect to 

whom an election is in effect for the 

taxable year under section 6013(g) to be 

treated as a resident of the United 

States; 

(ii) A former citizen or long-term 

resident (within the meaning of section 

877(e)(2)) who expatriated after June 3, 

2004, and has not complied with the 

requirements of section 7701(n); or 

(iii) An individual who is treated as 

a citizen or resident of the United States 

for the taxable year under section 

877(g). 

(k) Established securities market. For 

purposes of section 409A and the 

regulations thereunder, the term 

established securities market means an 

established securities market within the 

meaning of § 1.897–1(m). 

(l) Stock right. For purposes of section 

409A and these regulations, the term 

stock right means a stock option (other 

than an incentive stock option described 

in section 422 or an option granted 

pursuant to an employee stock purchase 

57970 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

plan described in section 423) or a stock 

appreciation right. 

(m) Separation pay arrangement. For 

purposes of section 409A and the 

regulations thereunder, the term 

separation pay arrangement means any 

arrangement that provides separation 

pay or, where an arrangement provides 

both amounts that are separation pay 

and that are not separation pay, that 

portion of the arrangement that provides 

separation pay. For purposes of this 

paragraph (m), the term separation pay 

means any amount of compensation 

where one of the conditions to the right 

to the payment is a separation from 

service, whether voluntary or 

involuntary, including payments in the 

form of reimbursements of expenses 

incurred, and the provision of other 

taxable benefits. Separation pay 

includes amounts payable due to a 

separation from service, regardless of 

whether payment is conditioned upon 

the execution of a release of claims, 

noncompetition or nondisclosure 

provisions, or other similar requirement. 

Notwithstanding the foregoing, any 

amount, or entitlement to any amount, 

that acts as a substitute for, or 

replacement of, amounts deferred by the 

service recipient under a separate 

nonqualified deferred compensation 

plan constitutes a payment of 

compensation or deferral of 

compensation under the separate 

nonqualified deferred compensation 

plan, and does not constitute separation 

pay. 

§ 1.409A–2 Deferral elections. 

(a) Initial elections as to the time and 

form of payment—(1) In general. An 

arrangement that is, or constitutes part 

of, a nonqualified deferred 

compensation plan meets the 

requirements of section 409A(a)(4)(B) 

only if the arrangement provides that 

compensation for services performed 

during a service provider’s taxable year 

(the service year) may be deferred at the 

service provider’s election only if the 

election to defer such compensation is 

made and becomes irrevocable not later 

than the end of such period as may be 

permitted in this paragraph (a). An 

election will not be considered to be 

revocable merely because the service 

provider may make an election to 

change the time and form of payment 

pursuant to paragraph (b) of this section. 

Whether an arrangement provides a 

service provider an opportunity to elect 

the time or form of payment of 

compensation is determined based upon 

all the facts and circumstances 

surrounding the determination of the 

time and form of payment of the 

compensation. For purposes of this 

section, an election to defer includes an 

election as to the time of the payment, 

an election as to the form of the 

payment or an election as to both the 

time and the form of the payment, but 

does not include an election as to the 

medium of payment (for example, an 

election between a payment of cash or 

a payment of property). Except as 

otherwise provided in these regulations, 

an election will not be considered made 

until such election becomes irrevocable 

under the terms of the relevant 

arrangement. Thus, a plan may provide 

that an election to defer may be changed 

at any time prior to the last permissible 

date for making such an election. Where 

an arrangement provides the service 

provider a right to make an initial 

deferral election, and further provides 

that the election remains in effect until 

terminated or modified by the service 

provider, the election will be treated as 

made as of the date such election 

becomes irrevocable as to compensation 

for services performed during the 

relevant service year. For example, 

where an arrangement provides that a 

service provider’s election to defer a set 

percentage will remain in effect until 

changed or revoked, but that as of each 

December 31 the election becomes 

irrevocable with respect to salary 

payable with respect to services 

performed in the immediately following 

year, the initial deferral election with 

respect to salary payable with respect to 

services performed in the immediately 

following year will be deemed to have 

been made as of the December 31 upon 

which the election became irrevocable. 

(2) General rule. An arrangement that 

is, or constitutes part of, a nonqualified 

deferred compensation plan meets the 

requirements of section 409A(a)(4)(B) if 

the plan provides that compensation for 

services performed during a service 

provider’s taxable year (the service year) 

may be deferred at the service provider’s 

election only if the election to defer 

such compensation is made not later 

than the close of the service provider’s 

taxable year next preceding the service 

year. 

(3) Initial deferral election with 

respect to short-term deferrals. With 

respect to a legally binding right to a 

payment of compensation in a 

subsequent taxable year that, absent a 

deferral election, would not be treated 

as a deferral of compensation pursuant 

to § 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 § 1.409A–3(g)(5)) 

without regard to the 5-year additional 

deferral requirement. 

(4) Initial deferral election with 

respect to certain forfeitable rights. With 

respect to a legally binding right to a 

payment in a subsequent year that is 

subject to a forfeiture condition 

requiring the service provider’s 

continued services for a period of at 

least 12 months from the date the 

service provider obtains the legally 

binding right, an election to defer such 

compensation may be made on or before 

the 30th day after the service provider 

obtains the legally binding right to the 

compensation, provided that the 

election is made at least 12 months in 

advance of the earliest date at which the 

forfeiture condition could lapse. 

(5) Initial deferral election with 

respect to a service recipient with a 

fiscal year other than the calendar year. 

In the case of a service recipient with a 

fiscal year other than the calendar year, 

a plan may provide that fiscal year 

compensation may be deferred at the 

service provider’s election only if the 

election to defer such compensation is 

made not later than the close of the 

service recipient’s fiscal year next 

preceding the first fiscal year in which 

are performed any services for which 

such compensation is payable. For 

purposes of this paragraph (a)(5), the 

term fiscal year compensation means 

compensation relating to a period of 

service coextensive with one or more 

consecutive fiscal years of the service 

recipient, of which no amount is paid or 

payable during the service period. For 

example, fiscal year compensation 

generally would include a bonus based 

on a service period of the two 

consecutive fiscal years ending 

September 30, 2009, where the amount 

will be paid after the completion of the 

service period, but would not include 

either a bonus based on a calendar year 

service period or salary that would 

otherwise be paid during the service 

recipient’s fiscal year. 

(6) First year of eligibility. In the case 

of the first year in which a service 

provider becomes eligible to participate 

in a plan (as defined in § 1.409A–1(c)), 

the service provider may make an initial 

deferral election within 30 days after the 

date the service provider becomes 

eligible to participate in such plan, with 

respect to compensation paid for 

services to be performed subsequent to 

the election. In the case of a plan that 

does not provide for service provider 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57971 

elections with respect to the time or 

form of a payment, the time and form 

of the payment must be specified on or 

before the date that is 30 days after the 

date the service provider becomes 

eligible to participate in such plan. For 

compensation that is earned based upon 

a specified performance period (for 

example, an annual bonus), where a 

deferral election is made in the first year 

of eligibility but after the beginning of 

the service period, the election will be 

deemed to apply to compensation paid 

for services performed subsequent to the 

election if the election applies to the 

portion of the compensation equal to the 

total amount of the compensation for 

the service period multiplied by the 

ratio of the number of days remaining in 

the performance period after the 

election over the total number of days 

in the performance period. 

(7) Performance-based compensation. 

In the case of any performance-based 

compensation based upon a 

performance period of at least 12 

months, provided that the service 

provider performed services 

continuously from a date no later than 

the date upon which the performance 

criteria are established through a date 

no earlier than the date upon which the 

service provider makes an initial 

deferral election, an initial deferral 

election may be made with respect to 

such performance-based compensation 

no later than the date that is six months 

before the end of the performance 

period, provided that in no event may 

an election to defer performance-based 

compensation be made after such 

compensation has become both 

substantially certain to be paid and 

readily ascertainable. 

(8) Nonqualified deferred 

compensation arrangements linked to 

qualified plans. With respect to an 

amount deferred under an arrangement 

that is, or constitutes part of, a 

nonqualified deferred compensation 

plan, where under the terms of the 

nonqualified deferred compensation 

arrangement the amount deferred under 

the plan is the amount determined 

under the formula under which benefits 

are determined under a qualified 

employer plan (as defined in § 1.409A–

1(a)(2)) applied without respect to one 

or more limitations applicable to 

qualified employer plans under the 

Internal Revenue Code or other 

applicable law, or is determined as an 

amount offset by some or all of the 

benefits provided under the qualified 

employer plan, the operation of the 

qualified employer plan with respect to 

changes in benefit limitations applicable 

to qualified employer plans under the 

Internal Revenue Code or other 

applicable law does not constitute a 

deferral election even if such operation 

results in an increase of amounts 

deferred under the nonqualified 

deferred compensation arrangement, 

provided that such operation does not 

otherwise result in a change in the time 

or form of a payment under the 

nonqualified deferred compensation 

plan. In addition, with respect to such 

a nonqualified deferred compensation 

arrangement, the following actions or 

failures to act will not constitute a 

deferral election under the nonqualified 

deferred compensation arrangement 

even if in accordance with the terms of 

the nonqualified deferred compensation 

arrangement, the actions or inactions 

result in an increase in the amounts 

deferred under the arrangement, 

provided that such actions or inactions 

do not otherwise affect the time or form 

of payment under the nonqualified 

deferred compensation plan: 

(i) A service provider’s action or 

inaction under the qualified plan with 

respect to whether to elect to receive a 

subsidized benefit or an ancillary 

benefit under the qualified plan. 

(ii) The amendment of a qualified 

plan to add or remove a subsidized 

benefit or an ancillary benefit, or to 

freeze or limit future accruals of benefits 

under the qualified plan. 

(iii) A service provider’s action or 

inaction under a qualified plan subject 

to section 402(g), including an 

adjustment to a deferral election under 

the qualified plan subject to section 

402(g), provided that for any given 

calendar year, the service provider’s 

action or inaction does not result in an 

increase in the amounts deferred under 

all nonqualified deferred compensation 

arrangements in which the service 

provider participates in excess of the 

limit with respect to elective deferrals 

under section 402(g) in effect for the 

taxable year in which such action or 

inaction occurs. 

(iv) A service provider’s action or 

inaction under a qualified plan with 

respect to elective deferrals or after-tax 

contributions by the service provider to 

the qualified plan that affects the 

amounts that are credited under a 

nonqualified deferred compensation 

arrangement as matching amounts or 

other amounts contingent on service 

provider elective deferrals or after-tax 

contributions, provided that such 

matching or contingent amounts, as 

applicable, are either forfeited or never 

credited under the nonqualified 

deferred compensation arrangement in 

the absence of such service provider’s 

elective deferral or after-tax 

contribution, and provided further that 

all of the service provider’s actions or 

inactions do not result in an increase 

during such taxable year in the amounts 

deferred under all nonqualified deferred 

compensation arrangements in which 

the service provider participates in 

excess of the limit with respect to 

elective deferrals under section 402(g) 

in effect for the taxable year in which 

such action or inaction occurs. See 

paragraph (b)(6) of this section, Example 

12 and Example 13. 

(9) Separation pay. In the case of 

separation pay (as defined in § 1.409A–

1(b)(9)(i)) due to an actual involuntary 

separation from service, where such 

separation pay is the subject of bona 

fide, arm’s length negotiations, the 

initial deferral election may be made at 

any time up to the time the service 

provider obtains a legally binding right 

to the payment. In the case of separation 

pay due to participation in a window 

program (as defined in § 1.409A–

1(b)(9)(v)), the initial deferral election 

may be made at any time up to the time 

the election to participate in the 

window program becomes irrevocable. 

(10) Commissions. For purposes of 

this paragraph (a), in the case of 

commission compensation, a service 

provider earning such compensation is 

treated as providing the services to 

which such compensation relates only 

in the year in which the customer remits 

payment to the service recipient. For 

purposes of this paragraph (a)(10), the 

term commission compensation means 

compensation or portions of 

compensation earned by a service 

provider if a substantial portion of the 

services provided by such service 

provider to a service recipient consist of 

the direct sale of a product or service to 

a customer, the compensation paid by 

the service recipient to the service 

provider consists of either a portion of 

the purchase price for the product or 

service or an amount calculated solely 

by reference to the volume of sales, and 

payment of the compensation is 

contingent upon the service recipient 

receiving payment from an unrelated 

customer for the product or services. For 

this purpose, a customer is treated as an 

unrelated customer only if the customer 

is not related to either the service 

provider or the service recipient. A 

person is treated as related to another 

person if the person would be treated as 

related to the other person under 

§ 1.409A–1(f)(3)(ii) or the person would 

be treated as providing management 

services to the other person under 

§ 1.409A–1(f)(3)(iv). 

(11) Initial deferral elections with 

respect to compensation paid for final 

payroll period—(i) In general. Unless an 

arrangement provides otherwise, 

compensation payable after the last day 

57972 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

of the service provider’s taxable year 

solely for services performed during the 

final payroll period described in section 

3401(b) containing the last day of the 

service provider’s taxable year or, with 

respect to a non-employee service 

provider, a period not longer than the 

payroll period described in section 

3401(b), where such amount is payable 

pursuant to the timing arrangement 

under which the service recipient 

normally compensates service providers 

for services performed during a payroll 

period described in section 3401(b), or 

with respect to a non-employee service 

provider, a period not longer than the 

payroll period described in section 

3401(b), is treated as compensation for 

services performed in the subsequent 

taxable year. The preceding sentence 

does not apply to any compensation 

paid during such period for services 

performed during any period other than 

such final payroll period, such as a 

payment of an annual bonus. Any 

amendment of an arrangement after 

December 31, 2006, to add a provision 

providing for a differing treatment of 

such compensation may not be effective 

for 12 months from the date the 

amendment is executed and enacted. 

(ii) Transition rule. For purposes of 

this paragraph (a)(11), an arrangement 

that was adopted and effective before 

December 31, 2006, whether written or 

unwritten, will be treated as designating 

such compensation for service 

performed in the taxable year in which 

the payroll period ends, unless 

otherwise set forth in writing before 

December 31, 2006. 

(12) Designation of time and form of 

payment with respect to a nonelective 

arrangement. An arrangement that 

provides for a deferral of compensation 

for services performed during a service 

provider’s taxable year that does not 

provide the service provider with an 

opportunity to elect the time of payment 

of such compensation must specify the 

time of payment no later than the time 

the service provider first has a legally 

binding right to the compensation. 

Similarly, an arrangement that provides 

for a deferral of compensation for 

services performed during a service 

provider’s taxable year that does not 

provide the service provider with an 

opportunity to elect the form of 

payment of such compensation must 

specify the form of payment no later 

than the time the service provider first 

has a legally binding right to the 

compensation. Such designation shall 

be treated as an initial deferral election 

for purposes of this section. 

(13) Designation of time and form of 

payment with respect to earnings. An 

arrangement that provides for actual or 

notional earnings to be credited on 

amounts of deferred compensation may 

specify, in accordance with the 

requirements of this paragraph (a), that 

such earnings will be paid by a date not 

later than the 15th day of the third 

month following the calendar year for 

which the earnings are credited. To 

satisfy the requirements of this 

paragraph (a)(13), actual or notional 

earnings must be credited at least 

annually and the measure for such 

earnings must be either a specified, 

nondiscretionary interest rate (or a 

specified, nondiscretionary formula 

describing an interest rate such as, for 

example, the interest on a Treasury 

bond + 2 percent) or a predetermined 

actual investment within the meaning of 

§ 31.3121(v)(2)–1(d)(2) of this chapter. 

For these purposes, a right to dividend 

equivalents with respect to a specified 

number of shares of service recipient 

stock (as defined in § 1.409A–

1(b)(5)(iii)) may be treated as a right to 

actual or notional earnings on an 

amount of deferred compensation. 

(b) Subsequent changes in time and 

form of payment—(1) In general. The 

requirements of section 409A(a)(4)(C) 

are met if, in the case of a plan that 

permits a subsequent election to delay 

a payment or to change the form of 

payment of an amount of deferred 

compensation, the following conditions 

are met: 

(i) The plan requires that such 

election may not take effect until at least 

12 months after the date on which the 

election is made. 

(ii) In the case of an election related 

to a payment not described in § 1.409A–

3(a)(2) (payment on account of 

disability), § 1.409A–3(a)(3) (payment 

on account of death) or § 1.409A–3(a)(6) 

(payment on account of the occurrence 

of an unforeseeable emergency), the 

plan requires that the payment with 

respect to which such election is made 

be deferred for a period of not less than 

5 years from the date such payment 

would otherwise have been paid (or in 

the case of a life annuity or installment 

payments treated as a single payment, 5 

years from the date the first amount was 

scheduled to be paid). 

(iii) The plan requires that any 

election related to a payment described 

in § 1.409A–3(a)(4) (payment at a 

specified time or pursuant to a fixed 

schedule) may not be made less than 12 

months prior to the date the payment is 

scheduled to be paid (or in the case of 

a life annuity or installment payments 

treated as a single payment, 12 months 

prior to the date the first amount was 

scheduled to be paid). 

(2) Definition of payments for 

purposes of subsequent changes in the 

time or form of payment—(i) In general. 

Except as provided in paragraphs 

(b)(2)(ii) and (iii) of this section, the 

term payment refers to each separately 

identified amount to which a service 

provider is entitled to payment under a 

plan on a determinable date, and 

includes amounts applied for the benefit 

of the service provider. An amount is 

separately identified only if the amount 

may be objectively determined. For 

example, an amount identified as 10 

percent of the account balance as of a 

specified payment date would be a 

separately identified amount. A 

payment includes the provision of any 

taxable benefit, including payment in 

cash or in kind. In addition, a payment 

includes, but is not limited to, the 

transfer, cancellation or reduction of an 

amount of deferred compensation in 

exchange for benefits under a welfare 

benefit plan, fringe benefit excludible 

under section 119 or section 132, or any 

other benefit that is excluded from gross 

income. 

(ii) Life annuities. The entitlement to 

a life annuity is treated as the 

entitlement to a single payment. For 

purposes of this paragraph (b)(2)(ii), the 

term life annuity means a series of 

substantially equal periodic payments, 

payable not less frequently than 

annually, for the life (or life expectancy) 

of the service provider or the joint lives 

(or life expectancies) of the service 

provider and the service provider’s 

designated beneficiary. A change in the 

form of a payment from one type of life 

annuity to another type of life annuity 

before any annuity payment has been 

made is not considered a change in the 

time and form of a payment, provided 

that the annuities are actuarially 

equivalent applying reasonable actuarial 

assumptions. 

(iii) Installment payments. The 

entitlement to a series of installment 

payments that is not a life annuity is 

treated as the entitlement to a single 

payment, unless the arrangement 

provides at all times with respect to the 

amount deferred that the right to the 

series of installment payments is to be 

treated as a right to a series of separate 

payments. For purposes of this 

paragraph (b)(2)(iii), a series of 

installment payments refers to an 

entitlement to the payment of a series of 

substantially equal periodic amounts to 

be paid over a predetermined period of 

years, except to the extent any increase 

in the amount reflects reasonable 

earnings through the date the amount is 

paid. 

(iv) Transition rule. For purposes of 

this section, an arrangement that was 

adopted and effective before December 

31, 2006, whether written or unwritten, 

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that fails to make a designation as to 

whether the entitlement to a series of 

payments is to be treated as an 

entitlement to a series of separate 

payments under paragraph (b)(2)(iii) of 

this section is treated as having made 

such designation as of the later of the 

date on which the arrangement was 

adopted or became effective, provided 

that such designation is set forth in 

writing before December 31, 2006. 

(3) Coordination with prohibition 

against acceleration of payments. For 

purposes of applying the prohibition 

against the acceleration of payments 

contained in § 1.409A–3(c), the 

definition of payment is the same as the 

definition provided in paragraph (b)(2) 

of this section. However, even though a 

change in the form of a payment that 

results in a more rapid schedule for 

payments generally may not constitute 

an acceleration of a payment, the change 

in the form of payment must comply 

with the subsequent deferral rules. For 

example, although a change in form 

from a 10-year installment payment 

treated as a single payment to a lumpsum payment would not constitute an 

acceleration, the change in the form of 

the payment must still comply with the 

requirements of paragraph (b)(1) of this 

section, generally meaning that the 

election to change to a lump-sum 

payment could not be effective for 12 

months and the lump-sum payment 

could not be made until at least 5 years 

after the date the installment payments 

were scheduled to commence. 

(4) Application to multiple payment 

events. In the case of a plan that permits 

a payment upon each of a number of 

potential permissible payment events, 

such as the earlier of a fixed date or 

separation from service, the 

requirements of paragraph (b)(1) of this 

section are applied separately to each 

payment (as defined in paragraph (b)(2) 

of this section) due upon each payment 

event. Notwithstanding the foregoing, 

the addition of a permissible payment 

event to amounts previously deferred is 

subject to the rules of this paragraph (b) 

where the addition of the permissible 

payment event may result in a change 

in the time or form of payment of the 

amount deferred. For application of the 

rules governing accelerations of 

payments to the addition of a 

permissible payment event to amounts 

deferred, see § 1.409A–3. 

(5) Delay of payments under certain 

circumstances. A plan may provide, or 

be amended to provide, that a payment 

will be delayed to a date after the 

designated payment date under any of 

the following circumstances, and the 

provision will not fail to meet the 

requirements of establishing a 

permissible payment event and the 

delay in the payment will not constitute 

a subsequent deferral election, provided 

that once such a provision is applicable 

to an amount of deferred compensation, 

any failure to apply such a provision or 

modification of the plan to remove such 

a provision will constitute an 

acceleration of any payment to which 

such provision applied: 

(i) Payments subject to section 

162(m). A plan may provide that a 

payment will be delayed where the 

service recipient reasonably anticipates 

that the service recipient’s deduction 

with respect to such payment otherwise 

would be limited or eliminated by 

application of section 162(m); provided 

that the terms of the arrangement 

require the payment to be made either 

at the earliest date at which the service 

recipient reasonably anticipates that the 

deduction of the payment of the amount 

will not be limited or eliminated by 

application of section 162(m) or the 

calendar year in which the service 

provider separates from service. 

(ii) Payments that would violate a 

loan covenant or similar contractual 

requirement. A plan may provide that a 

payment will be delayed where the 

service recipient reasonably anticipates 

that the making of the payment will 

violate a term of a loan agreement to 

which the service recipient is a party, or 

other similar contract to which the 

service recipient is a party, and such 

violation will cause material harm to the 

service recipient; provided that the 

terms of the arrangement require the 

payment to be made at the earliest date 

at which the service recipient 

reasonably anticipates that the making 

of the payment will not cause such 

violation, or such violation will not 

cause material harm to the service 

recipient, and provided that the facts 

and circumstances indicate that the 

service recipient entered into such loan 

agreement (including such covenant) or 

other similar contract for legitimate 

business reasons, and not to avoid the 

restrictions on deferral elections and 

subsequent deferral elections under 

section 409A. 

(iii) Payments that would violate 

Federal securities laws or other 

applicable law. A plan may provide that 

a payment will be delayed where the 

service recipient reasonably anticipates 

that the making of the payment will 

violate Federal securities laws or other 

applicable law; provided that the terms 

of the arrangement require the payment 

to be made at the earliest date at which 

the service recipient reasonably 

anticipates that the making of the 

payment will not cause such violation. 

For purposes of this paragraph 

(b)(5)(iii), the making of a payment that 

would cause inclusion in gross income 

or the application of any penalty 

provision or other provision of the 

Internal Revenue Code is not treated as 

a violation of applicable law. 

(iv) Other events and conditions. A 

service recipient may delay a payment 

upon such other events and conditions 

as the Commissioner may prescribe in 

generally applicable guidance published 

in the Internal Revenue Bulletin. 

(6) Examples. The following examples 

illustrate the application of the 

provisions of this section: 

Example 1. Initial election to defer salary. 

Employee A is an individual employed by 

Employer X. Employer X sponsors an 

arrangement under which Employee A may 

elect to defer a percentage of Employee A’s 

salary. Employee A has participated in the 

arrangement in prior years. To satisfy the 

requirements of this section with respect to 

salary earned in calendar year 2008, if 

Employee A elects to defer any amount of 

such salary, the deferral election (including 

an election as to the time and form of 

payment) must be made no later than 

December 31, 2007. 

Example 2. Designation of time and form 

of payment where an initial deferral election 

is not provided. Employee A is an individual 

employed by Employer X. Employer X has a 

fiscal year ending September 30. On July 1, 

2007, Employer X enters into a legally 

binding obligation to pay Employee A a 

$10,000 bonus. The amount is not subject to 

a substantial risk of forfeiture. Employer X 

does not provide Employee A an election as 

to the time and form of payment. Unless the 

amount is paid in accordance with the shortterm deferral rule of § 1.409A–1(b)(4), to 

satisfy the requirements of this section, 

Employer X must specify the time and form 

of payment on or before July 1, 2007. 

Example 3. Initial election to defer bonus 

payable based on services during calendar 

year. Employee A is an individual employed 

by Employer X. Employer X has a fiscal year 

ending September 30. Employee A 

participates in a bonus plan under which 

Employee A is entitled to a bonus for services 

performed during the calendar year that, 

absent an election by Employee A, will be 

paid on March 15 of the following year. The 

amount is not subject to a substantial risk of 

forfeiture and does not qualify as 

performance based compensation. If 

Employee A elects to defer the payment of 

the bonus with respect to calendar year 2008, 

to satisfy the requirements of this paragraph, 

Employee A must elect the time and form of 

payment not later than December 31, 2007. 

Example 4. Initial election to defer bonus 

payable based on services during fiscal year 

other than calendar year. Employee A is an 

individual employed by Employer X. 

Employer X has a fiscal year ending 

September 30. Employee A participates in a 

bonus plan under which Employee A is 

entitled to a bonus for services performed 

during Employer X’s fiscal year that, absent 

an election by Employee A, will be paid on 

December 15 of the calendar year in which 

57974 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

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 § 1.409A–1(e). 

The amount qualifies as fiscal year 

compensation. If Employee A elects to defer 

the payment of the amount related to the 

fiscal year ending September 30, 2008, to 

satisfy the requirements of this section 

Employee A must elect the time and form of 

payment not later than September 30, 2007. 

Example 5. Initial election to defer bonus 

payable only if service provider completes at 

least 12 months of services after the election. 

Employee A is an individual employed by 

Employer X. Employer X has a calendar year 

fiscal year. On March 1, 2006, Employer X 

grants Employee A a $10,000 bonus, payable 

on March 1, 2008, provided that Employee A 

continues performing services as an 

employee of Employer X through March 1, 

2008. The amount does not qualify as 

performance-based compensation as 

described in § 1.409A–1(e), and Employee A 

already participates in another account 

balance nonqualified deferred compensation 

plan. Employee A may make an initial 

deferral election on or before March 31, 2006 

(within 30 days after obtaining a legally 

binding right), because at least 12 months of 

additional services are required after the date 

of election for the risk of forfeiture to lapse. 

Example 6. Initial election to defer bonus 

that would otherwise constitute a short-term 

deferral. The same facts as Example 5, except 

that Employee A does not make an initial 

deferral election on or before March 31, 2006. 

Because the right to the compensation would 

not be treated as a deferral of compensation 

pursuant to § 1.409A–1(b)(4) absent a deferral 

election (because the arrangement would be 

treated as a short-term deferral), Employee A 

may make an initial deferral election 

provided that the election may not become 

effective for 12 months and must defer the 

payment at least 5 years from March 1, 2008 

(the first date the payment could become 

substantially vested). Accordingly, Employee 

A may make an election before March 1, 

2007, provided that the election defers the 

payment to a date on or after March 1, 2013 

(other than a payment due to death, 

disability, unforeseeable emergency, or a 

change in control event). 

Example 7. Initial election to defer 

commissions. Employee A is an individual 

employed by Employer X. Employer X has a 

calendar year fiscal year. As part of Employee 

A’s services for Employer X, Employee A 

sells refrigerators. Under the employment 

arrangement, Employee A is entitled to 10 

percent of the sales price of any refrigerator 

Employee A sells, payable only upon the 

receipt of payment from the customer who 

purchased the refrigerator. For purposes of 

the initial deferral rule, Employee A is 

treated as performing the services related to 

each refrigerator sale in the taxable year in 

which each customer pays for the 

refrigerator. 

Example 8. Initial election to defer renewal 

commissions. The same facts as Example 7, 

except that Employee A also sells warranties 

related to the refrigerators sold. Under the 

warranty arrangement, refrigerator warranty 

customers are entitled in a future year to 

extend the warranty for an additional cost to 

be paid at the time of the extension. Under 

Employee A’s arrangement with Employer X, 

Employee A is entitled to 10 percent of the 

amount paid for an extension of any 

warranty, payable upon the receipt of 

payment from the customer extending the 

warranty. For purposes of the initial deferral 

rule, Employee A is treated as performing the 

services related to the amount paid for the 

extension of the warranty in the taxable year 

in which the customer pays for the warranty 

extension. 

Example 9. Initial election to defer 

negotiated separation pay. Employee A is an 

individual employed by Employer X. Under 

the terms of a separation pay arrangement, 

Employee A is entitled upon an involuntary 

separation from service to an amount equal 

to two weeks of pay for every year of service 

at Employer X. Employer X decides to 

terminate Employee A’s employment 

involuntarily. As part of the process of 

terminating Employee A, Employer X enters 

into bona fide, arm’s length negotiations with 

respect to the terms of Employee A’s 

termination of employment. As part of the 

process, Employer X offers Employee A an 

amount that is in addition to any amounts to 

which Employee A is otherwise entitled, 

payable either as a lump sum payment at the 

end of three years or in three annual 

payments starting at the date of termination 

of employment. The election of the time and 

form of payment by Employee A may be 

made at any time before Employee A accepts 

the offer and obtains a legally binding right 

to the additional amount. 

Example 10. Election of time and form of 

payments under a window program. 

Employee A is an individual employed by 

Employer X. Employer X establishes a 

window program, as defined in § 1.409A–

1(b)(9)(v). Individuals who elect to terminate 

employment under the window program are 

entitled to receive an amount equal to two 

weeks pay multiplied by every year of service 

with Employer X. The individuals 

participating in the window program may 

elect to receive the payment as either a lump 

sum payment payable on the first day of the 

month after making the election to 

participate in the window program, or as a 

payment of two equal annual installments on 

each January 1 of the first two years 

following the election to participate in the 

window program. Employee A is eligible to 

participate in the window program. 

Employee A may make the election as to the 

time and form of payment on or before the 

date Employee A’s election to participate in 

the window program becomes irrevocable. 

Example 11. Initial election to defer salary 

earned during final payroll period beginning 

in one calendar year and ending in the 

subsequent calendar year. Employee A 

performs services as an employee of 

Employer X. Employer X pays the salary of 

its employees, including Employee A, on a 

bi-weekly basis. One bi-weekly payroll 

period runs from December 24, 2006, through 

January 6, 2007, with a scheduled payment 

date of January 13, 2001. Employer X 

sponsors, and Employee A participates in, a 

nonqualified deferred compensation 

arrangement under which Employee A may 

defer a specified percentage of his annual 

salary. The arrangement does not specify that 

any salary compensation paid for the payroll 

period in which falls January 1 is to be 

treated as compensation for services 

performed during the year preceding the year 

in which falls that January 1. For purposes 

of applying the initial deferral election rules, 

Employee A is deemed to have performed the 

services for the payroll period December 24, 

2006, through January 6, 2007, during the 

calendar year 2007. 

Example 12. Application of deferral 

election rules and anti-acceleration rules to 

a section 401(k) wrap plan. Employee A 

participates in a qualified retirement plan 

under section 401(a) with a qualified cash or 

deferred arrangement under section 401(k). 

Employee A also participates in a 

nonqualified deferred compensation 

arrangement. Under the terms of the 

nonqualified deferred compensation 

arrangement, Employee A elects, on or before 

December 31, to defer a specified percentage 

of his salary for the subsequent calendar year. 

Under the terms of the nonqualified deferred 

compensation arrangement and the qualified 

plan, as of the earliest date administratively 

practicable following the end of the year in 

which the salary is earned, the maximum 

amount that may be deferred under the 

qualified cash or deferred arrangement (not 

in excess of the amount specified under 

section 402(g) for the plan year) is credited 

to Employee A’s account under the qualified 

plan, and Employee A’s deferral under the 

nonqualified deferred compensation 

arrangement is reduced by a corresponding 

amount. The reduction has no effect on any 

other nonqualified deferred compensation 

arrangement in which Employee A 

participates. The reduction of Employee A’s 

account under the nonqualified deferred 

compensation arrangement is not treated as 

an accelerated payment of deferred 

compensation for purposes of section 409A. 

Example 13. Application of deferral 

election rules and anti-acceleration rules to 

a nonqualified deferred compensation 

arrangement linked to a qualified defined 

benefit plan. Employee A participates in a 

qualified retirement plan that is a defined 

benefit plan. Employee A also participates in 

a nonqualified deferred compensation 

arrangement, under which the benefit 

payable is calculated under a formula, with 

that benefit then reduced by any benefit 

which Employee A has accrued under the 

qualified retirement plan. In 2007, Employee 

A fails to elect a subsidized benefit under the 

qualified retirement plan, with the effect that 

the amounts payable under the nonqualified 

deferred compensation arrangement are 

increased relative to the lesser benefit 

payable under the qualified plan. Also, in 

2007, Employer X amends the qualified 

retirement plan to increase benefits under the 

plan, resulting in a relative decrease in the 

amounts payable under the nonqualified 

deferred compensation arrangement relative 

to the greater benefit payable under the 

qualified plan. Neither of these actions 

constitute a deferral election or an 

acceleration of a payment under the 

nonqualified deferred compensation 

arrangement. 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57975 

Example 14. Subsequent deferral election. 

Employee A participates in a nonqualified 

deferred compensation arrangement. 

Employee A elects to be paid in a lump sum 

payment at the earlier of age 65 or separation 

from service. Employee A anticipates that he 

will work after age 65, and wishes to defer 

payment to a later date. Provided that 

Employee A continues in employment and 

makes the election by his 64th birthday, 

Employee A may elect to receive a lump sum 

payment at the earlier of age 70 or separation 

from service. 

Example 15. Grant of right to current 

payment of dividends paid with respect to 

restricted stock. Employer X grants Employee 

A stock that is not substantially vested for 

purposes of section 83, and Employee A does 

not make an election under section 83(b). As 

part of the restricted stock grant, Employee 

A receives the right to payments in an 

amount equal to the dividends payable with 

respect to the restricted stock. At the time 

Employer B grants Employee A the right to 

the dividend payments, the grant also 

specifies that each dividend payment will be 

made no later than the end of the calendar 

year in which the dividends are paid to 

shareholders of that class of stock or, if later, 

the 15th day of the third month following the 

date the dividends are paid to shareholders 

of that class of stock. The grant of the rights 

to dividend payments satisfies the 

requirement that deferred amounts be paid at 

a specified time or pursuant to a specified 

schedule. 

Example 16. Subsequent deferral election 

rule—change in form of payment from lump 

sum payment to life annuity. Employee A 

participates in a nonqualified deferred 

compensation arrangement. Employee A 

elects to be paid in a lump sum payment at 

age 65. Employee A wishes to change the 

payment form to a life annuity. Provided that 

Employee A makes the election on or before 

his 64th birthday, Employee A may elect to 

receive a life annuity commencing at age 70. 

Example 17. Subsequent deferral election 

rule—change in form of payment from life 

annuity to lump sum payment. Employee A 

participates in a nonqualified deferred 

compensation arrangement. Employee A 

elects to be paid in a life annuity at age 65. 

Employee A wishes to change the payment 

form to a lump sum payment. Provided that 

Employee A makes the election on or before 

his 64th birthday, Employee A may elect to 

receive a lump sum payment at age 70. 

Example 18. Subsequent deferral election 

rule—installment payments designated as 

separate payments. Employee A participates 

in a nonqualified deferred compensation 

arrangement that provides for payment in a 

series of 5 equal annual amounts, each 

designated as a separate payment. The first 

payment is scheduled to be made on January 

1, 2008. Provided that Employee A makes the 

election on or before January 1, 2007, 

Employee A may elect for the first payment 

to be made on January 1, 2013. If Employee 

A makes that election, the remaining 

payments may continue to be due upon 

January 1 of the four calendar years 

commencing on January 1, 2009. 

Example 19. Subsequent deferral election 

rule—change in form of payment from 

installment payments to lump sum payment. 

Employee A participates in a nonqualified 

deferred compensation arrangement that 

provides for payment in a series of 5 equal 

annual amounts that are not designated as a 

series of 5 separate payments. The first 

amount is scheduled to be paid on January 

1, 2008. Employee A wishes to receive the 

entire amount equal to the sum of all five of 

the amounts to be paid as a lump sum 

payment. Provided that Employee A makes 

the election on or before January 1, 2007, 

Employee A may elect to receive a lump sum 

payment on or after January 1, 2013. 

Example 20. Subsequent deferral election 

rule—change in time of payment from 

payment at specified age to payment at later 

of specified age or separation from service. 

Employee A participates in a nonqualified 

deferred compensation arrangement that 

provides for a lump sum payment at age 65. 

Employee A wishes to add a payment 

provision such that the payment is payable 

upon the later of a predetermined age or 

separation from service. Provided that 

Employee A makes such election on or before 

his 64th birthday, Employee A may elect to 

receive a lump sum payment upon the later 

of age 70 or separation from service. 

(c) Special rules for certain resident 

aliens. For the first calendar year in 

which an individual is classified as a 

resident alien, a nonqualified deferred 

compensation arrangement is deemed to 

meet the requirements of paragraph (a) 

of this section if, with respect to 

compensation payable for services 

performed during that first calendar 

year or with respect to compensation 

the right to which is subject to a 

substantial risk of forfeiture as of 

January 1 of that first calendar year, an 

initial deferral election is made by the 

end of such first calendar year, provided 

that the initial deferral election may not 

apply to amounts paid or first payable 

on or before the date of such initial 

deferral election. For any year 

subsequent to the first calendar year in 

which an individual is classified as a 

resident alien, this paragraph (c) does 

not apply, provided that a calendar year 

may again be treated as the first 

calendar year in which an individual is 

classified as a resident alien if such 

individual has not been classified as a 

resident alien for at least five 

consecutive calendar years immediately 

preceding the year in which the 

individual is again classified as a 

resident alien. 

§ 1.409A–3 Permissible payments. 

(a) In general. The requirements of 

this section are met only if the 

arrangement provides that an amount of 

deferred compensation may be paid 

only on account of one or more of the 

following: 

(1) The service provider’s separation 

from service (as defined in § 1.409A–

1(h)). 

(2) The service provider becoming 

disabled (in accordance with paragraph 

(g)(4) of this section). 

(3) The service provider’s death. 

(4) A time (or pursuant to a fixed 

schedule) specified under the plan (in 

accordance with paragraph (g)(1) of this 

section). 

(5) A change in the ownership or 

effective control of the corporation, or in 

the ownership of a substantial portion of 

the assets of the corporation (in 

accordance with paragraph (g)(5) of this 

section). 

(6) The occurrence of an 

unforeseeable emergency (in accordance 

with paragraph (g)(3) of this section). 

(b) Designation of payment upon a 

permissible payment event. Except as 

otherwise specified in this section, an 

arrangement provides for the payment 

upon an event described in paragraph 

(a)(1), (2), (3), (5) or (6) of this section 

if the arrangement provides for a 

payment date that is objectively 

determinable at the time the event 

occurs (for example, 3 months following 

the date of initial disability or December 

31 of the calendar year in which the 

disability first occurs). In addition, an 

arrangement may provide that a 

payment is to be made during an 

objectively determinable calendar year 

following the year in which the event 

occurs (for example, the calendar year 

following the year in which the service 

provider dies), provided that where no 

specific date within such calendar year 

is objectively determinable, the payment 

date is deemed to be January 1 of such 

calendar year for purposes of applying 

the subsequent deferral election rules of 

§ 1.409A–1(b)(4). An arrangement may 

provide for payment upon the earliest or 

latest of more than one event, provided 

that each event is described in 

paragraphs (a)(1) through (6) of this 

section. An arrangement may also 

provide that a payment upon an event 

described in paragraph (a)(1), (2), (3), (5) 

or (6) of this section is to be made in 

accordance with a fixed schedule that is 

objectively determinable based on the 

date of the event, provided that the 

schedule must be fixed at the time the 

permissible payment event is 

designated, and any change in the fixed 

schedule will constitute a change in the 

time and form of payment. For example, 

an arrangement may provide that a 

service provider is entitled to three 

substantially equal payments payable on 

each of the first three anniversaries of 

the date of the service provider’s 

separation from service. In addition, an 

arrangement may provide that payments 

are to be made pursuant to a schedule 

of payments based upon objectively 

determinable calendar years following 

57976 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

the year in which the event occurs, (for 

example, three substantially equal 

payments to be made during the three 

calendar years following the year in 

which the service provider dies), 

provided that where payment dates 

within such calendar years are not 

specified under the terms of the 

arrangement, the payment dates are 

deemed to be January 1 of such calendar 

years for purposes of applying the 

subsequent deferral election rules of 

§ 1.409A–2(b). 

(c) Designation of alternative specified 

dates or payment schedules based upon 

date of permissible event. In general, in 

the case of an arrangement that provides 

that a payment upon an event described 

in paragraph (a)(1), (2), (3), (5) or (6) of 

this section is to be made on an 

objectively determinable date or year in 

accordance with paragraph (b) of this 

section, or in accordance with a fixed 

schedule that is objectively 

determinable based on the date of the 

event in accordance with paragraph (b) 

of this section, the objectively 

determined date or fixed schedule must 

apply consistently regardless of the date 

on which the specified event occurs. 

However, an arrangement may allow for 

an alternative payment schedule if the 

event occurs on or before one (but not 

more than one) specified date. For 

example, an arrangement may provide 

that a service provider will receive a 

lump sum payment of the service 

provider’s entire benefit under the 

arrangement on the first day of the 

month following a separation from 

service before age 55, but will receive 5 

substantially equal annual payments 

commencing on the first day of the 

month following a separation from 

service on or after age 55. 

(d) When a payment is treated as 

made upon the designated payment 

date. Except as otherwise specified in 

this section, a payment is treated as 

made upon the date specified under the 

arrangement (including a date specified 

under paragraph (a)(4) of this section) if 

the payment is made at such date or a 

later date within the same calendar year 

or, if later, by the 15th day of the third 

calendar month following the date 

specified under the arrangement. If 

calculation of the amount of the 

payment is not administratively 

practicable due to events beyond the 

control of the service provider (or 

service provider’s estate), the payment 

will be treated as made upon the date 

specified under the arrangement if the 

payment is made during the first 

calendar year in which the payment is 

administratively practicable. Similarly, 

if the funds of the service recipient are 

not sufficient to make the payment at 

the date specified under the plan 

without jeopardizing the solvency of the 

service recipient, the payment will be 

treated as made upon the date specified 

under the arrangement if the payment is 

made during the first calendar year in 

which the funds of the service recipient 

are sufficient to make the payment 

without jeopardizing the solvency of the 

service recipient. 

(e) Disputed payments and refusals to 

pay. If a payment is not made, in whole 

or in part, as of the date specified under 

the arrangement because the service 

recipient refuses to make such payment, 

the payment will be treated as made 

upon the date specified under the 

arrangement if the service provider 

accepts the portion (if any) of the 

payment that the service recipient is 

willing to make (unless such acceptance 

will result in a forfeiture of the claim to 

the remaining amount), makes prompt 

and reasonable, good faith efforts to 

collect the payment, and the payment is 

made during the first calendar year in 

which the service recipient and the 

service provider enter into a legally 

binding settlement of such dispute, the 

service recipient concedes that the 

amount is payable, or the service 

recipient is required to make such 

payment pursuant to a final and 

nonappealable judgment or other 

binding decision. For purposes of this 

paragraph (e), a service recipient is not 

treated as having refused to make a 

payment where pursuant to the terms of 

the plan the service provider is required 

to request payment, or otherwise 

provide information or take any other 

action, and the service provider has 

failed to take such action. In addition, 

for purposes of this paragraph (e), the 

service provider is deemed to have 

requested that a payment not be made, 

rather than the service recipient having 

refused to make such payment, where 

the service recipient’s decision to refuse 

to make the payment is made by the 

service provider or a member of the 

service provider’s family (as defined in 

section 267(c)(4) applied as if the family 

of an individual includes the spouse of 

any member of the family), or any 

person or group of persons over whom 

the service provider or service 

provider’s family member has effective 

control, or any person any portion of 

whose compensation is controlled the 

service provider or service provider’s 

family member. 

(f) Special rule for certain resident 

aliens. An arrangement that is, or 

constitutes part of, a nonqualified 

deferred compensation plan is deemed 

to meet the requirements of this section 

with respect to any amount payable in 

the first calendar year in which a service 

provider is classified as a resident alien, 

and with respect to any amount payable 

in a subsequent calendar year if no later 

than the December 31 of the first 

calendar year in which the service 

provider is classified as a resident alien, 

the plan is amended as necessary so that 

the times and forms of payment of 

amounts payable in a subsequent year 

comply with the provisions of this 

section. For any year subsequent to the 

first calendar year in which an 

individual is classified as a resident 

alien, this paragraph (f) does not apply, 

provided that a calendar year may again 

be treated as the first calendar year in 

which an individual is classified as a 

resident alien if such individual has not 

been classified as a resident alien for at 

least five consecutive calendar years 

immediately preceding the year in 

which the service provider is again 

classified as a resident alien. 

(g) Definitions and special rules—(1) 

Specified time or fixed schedule. 

Amounts are payable at a specified time 

or pursuant to a fixed schedule if 

objectively determinable amounts are 

payable at a date or dates that are 

objectively determinable at the time the 

amount is deferred. An amount is 

objectively determinable for this 

purpose if the amount is specifically 

identified or if the amount may be 

determined pursuant to a 

nondiscretionary formula (for example, 

50 percent of an account balance). A 

specified time or fixed schedule also 

includes the designation of a calendar 

year or years that are objectively 

determinable at the time the amount is 

deferred, provided that for purposes of 

the application of the subsequent 

deferral rules contained in § 1.409A–

2(b), the specified time or fixed 

schedule of payments is deemed to refer 

to January 1 of the relevant calendar 

year or years. An arrangement may 

provide that a payment upon the lapse 

of a substantial risk of forfeiture is to be 

made in accordance with a fixed 

schedule that is objectively 

determinable based on the date the 

substantial risk of forfeiture lapses 

(disregarding any acceleration of the 

lapsing of the substantial risk of 

forfeiture other than due to the 

occurrence of a condition applicable as 

of the date the legally binding right to 

the payment arose that itself would 

constitute a substantial risk of 

forfeiture), provided that the schedule 

must be fixed at the time the time and 

form of payment are designated, and 

any change in the fixed schedule will 

constitute a change in the time and form 

of payment. For example, an 

arrangement that provides for a bonus 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57977 

payment subject to the condition that 

the service provider complete three 

years of service, but provided further 

that such requirement of continued 

services would lapse upon the 

occurrence of an initial public offering 

that if applied alone would subject the 

right to the payment to a substantial risk 

of forfeiture, may provide that a service 

provider is entitled to substantially 

equal payments on each of the first three 

anniversaries of the date the substantial 

risk of forfeiture lapses (the earlier of 

three years of service or the date of an 

initial public offering). 

(2) Required delay in payment to a 

specified employee pursuant to a 

separation from service. In the case of 

any specified employee (as defined in 

§ 1.409A–1(i)), the requirements of 

paragraph (a)(1) of this section 

permitting a payment upon a separation 

from service are satisfied only if 

payments may not be made before the 

date that is six months after the date of 

separation from service (or, if earlier, 

the date of death of the specified 

employee). The arrangement must 

provide the manner in which the sixmonth delay will be implemented in the 

case of a service provider who is a 

specified employee. For example, an 

arrangement may provide that payments 

to which a specified employee would 

otherwise be entitled during the first six 

months following the date of separation 

from service are accumulated and paid 

at another specified date or specified 

schedule, such as the first date of the 

seventh month following the date of 

separation from service. The 

arrangement may also provide that each 

installment payment to which a 

specified employee is entitled upon a 

separation from service is delayed by six 

months. A service recipient may amend 

a plan at any time to change the method 

for applying the six-month delay, 

provided that the amendment may not 

be effective for a period of 12 months. 

Notwithstanding the foregoing, an 

amendment to a plan may be effective 

immediately in the case of a service 

recipient that amends the arrangement 

prior to the date upon which the service 

recipient’s stock first becomes readily 

tradable on an established securities 

market. Notwithstanding the foregoing, 

this paragraph (g)(2) also does not apply 

to a payment made under the 

circumstances described in paragraph 

(h)(2)(i) (domestic relations order), 

(h)(2)(ii) (conflicts of interest), or 

(h)(2)(v) (payment of employment taxes) 

of this section. 

(3) Unforeseeable Emergency—(i) 

Definition. For purposes of paragraph 

(a)(6) of this section, an unforeseeable 

emergency is a severe financial hardship 

of the service provider or beneficiary 

resulting from an illness or accident of 

the service provider or beneficiary, the 

service provider’s or beneficiary’s 

spouse, or the service provider’s or 

beneficiary’s dependent (as defined in 

section 152(a)); loss of the service 

provider’s or beneficiary’s property due 

to casualty (including the need to 

rebuild a home following damage to a 

home not otherwise covered by 

insurance, for example, not as a result 

of a natural disaster); or other similar 

extraordinary and unforeseeable 

circumstances arising as a result of 

events beyond the control of the service 

provider or beneficiary. For example, 

the imminent foreclosure of or eviction 

from the service provider’s or 

beneficiary’s primary residence may 

constitute an unforeseeable emergency. 

In addition, the need to pay for medical 

expenses, including non-refundable 

deductibles, as well as for the costs of 

prescription drug medication, may 

constitute an unforeseeable emergency. 

Finally, the need to pay for the funeral 

expenses of a spouse or a dependent (as 

defined in section 152(a)) may also 

constitute an unforeseeable emergency. 

Except as otherwise provided in this 

paragraph (g)(3)(i), the purchase of a 

home and the payment of college tuition 

are not unforeseeable emergencies. 

Whether a service provider or 

beneficiary is faced with an 

unforeseeable emergency permitting a 

distribution under this paragraph is to 

be determined based on the relevant 

facts and circumstances of each case, 

but, in any case, a distribution on 

account of unforeseeable emergency 

may not be made to the extent that such 

emergency is or may be relieved through 

reimbursement or compensation from 

insurance or otherwise, by liquidation 

of the service provider’s assets, to the 

extent the liquidation of such assets 

would not cause severe financial 

hardship, or by cessation of deferrals 

under the arrangement. An arrangement 

may provide for a payment upon any 

unforeseeable emergency, but does not 

have to provide for a payment upon all 

unforeseeable emergencies, provided 

that any event upon which a payment 

may be made qualifies as an 

unforeseeable emergency. 

(ii) Amount of payment permitted 

upon an unforeseeable emergency. 

Distributions because of an 

unforeseeable emergency must be 

limited to the amount reasonably 

necessary to satisfy the emergency need 

(which may include amounts necessary 

to pay any Federal, state, or local 

income taxes or penalties reasonably 

anticipated to result from the 

distribution). Determinations of 

amounts reasonably necessary to satisfy 

the emergency need must take into 

account any additional compensation 

that is available if the plan provides for 

cancellation of a deferral election upon 

a payment due to an unforeseeable 

emergency. See paragraph (h)(2)(vii) of 

this section. The payment may be made 

from any arrangement in which the 

service provider participates that 

provides for payment upon an 

unforeseeable emergency, provided that 

the arrangement under which the 

payment was made must be designated 

at the time of payment. 

(4) Disability—(i) In general. For 

purposes of this section, a service 

provider is considered disabled if the 

service provider meets one of the 

following requirements: 

(A) The service provider is unable to 

engage in any substantial gainful 

activity by reason of any medically 

determinable physical or mental 

impairment that can be expected to 

result in death or can be expect to last 

for a continuous period of not less than 

12 months. 

(B) The service provider is, by reason 

of any medically determinable physical 

or mental impairment that can be 

expected to result in death or can be 

expected to last for a continuous period 

of not less than 12 months, receiving 

income replacement benefits for a 

period of not less than 3 months under 

an accident and health plan covering 

employees of the service provider’s 

employer. 

(ii) Limited plan definition of 

disability. An arrangement may provide 

for a payment upon any disability, and 

need not provide for a payment upon all 

disabilities, provided that any disability 

upon which a payment may be made 

under the arrangement complies with 

the provisions of this paragraph (g)(4). 

(iii) Determination of disability. An 

arrangement may provide that a service 

provider will be deemed disabled if 

determined to be totally disabled by the 

Social Security Administration. An 

arrangement may also provide that a 

service provider will be deemed 

disabled if determined to be disabled in 

accordance with a disability insurance 

program, provided that the definition of 

disability applied under such disability 

insurance program complies with the 

requirements of this paragraph (g)(4). 

(5) Change in the ownership or 

effective control of a corporation, or a 

change in the ownership of a substantial 

portion of the assets of a corporation—

(i) In general. Pursuant to section 

409A(a)(2)(A)(v), an arrangement may 

permit a payment upon the occurrence 

of a change in the ownership of the 

57978 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

corporation (as defined in paragraph 

(g)(5)(v) of this section), a change in 

effective control of the corporation (as 

defined in paragraph (g)(5)(vi) of this 

section), or a change in the ownership 

of a substantial portion of the assets of 

the corporation (as defined in paragraph 

(g)(5)(vii) of this section) (collectively 

referred to as a change in control event). 

To qualify as a change in control event, 

the occurrence of the event must be 

objectively determinable and any 

requirement that any other person, such 

as a plan administrator or board of 

directors compensation committee, 

certify the occurrence of a change in 

control event must be strictly 

ministerial and not involve any 

discretionary authority. The 

arrangement may provide for a payment 

on any change in control event, and 

need not provide for a payment on all 

such events, provided that each event 

upon which a payment is provided 

qualifies as a change in control event. 

For rules regarding the ability of the 

service recipient to terminate the 

arrangement and pay amounts of 

deferred compensation upon a change 

in control event, see paragraph 

(h)(2)(viii)(B) of this section. 

(ii) Identification of relevant 

corporation—(A) In general. To 

constitute a change in control event as 

to the service provider, the change in 

control event must relate to—

(1) The corporation for whom the 

service provider is performing services 

at the time of the change in control 

event; 

(2) The corporation that is liable for 

the payment of the deferred 

compensation (or all corporations liable 

for the payment if more than one 

corporation is liable); or 

(3) A corporation that is a majority 

shareholder of a corporation identified 

in paragraph (g)(5)(ii)(A)(1) or (2) of this 

section, or any corporation in a chain of 

corporations in which each corporation 

is a majority shareholder of another 

corporation in the chain, ending in a 

corporation identified in paragraph 

(g)(5)(ii)(A)(1) or (2) of this section. 

(B) Majority shareholder. For 

purposes of this paragraph (g)(5)(ii), a 

majority shareholder is a shareholder 

owning more than 50 percent of the 

total fair market value and total voting 

power of such corporation. 

(C) Example. The following example 

illustrates the rules of this paragraph 

(g)(5)(ii): 

Example. Corporation A is a majority 

shareholder of Corporation B, which is a 

majority shareholder of Corporation C. A 

change in ownership of Corporation B 

constitutes a change in control event to 

service providers performing services for 

Corporation B or Corporation C, and to 

service providers for which Corporation B or 

Corporation C is solely liable for payments 

under the plan (for example, former 

employees), but is not a change in control 

event as to Corporation A or any other 

corporation of which Corporation A is a 

majority shareholder. Notwithstanding the 

foregoing, a sale of Corporation B may 

constitute an independent change in control 

event for Corporation A, Corporation B and 

Corporation C if the sale constitutes a change 

in the ownership of a substantial portion of 

Corporation A’s assets (see paragraph 

(g)(5)(vii) of this section). 

(iii) Attribution of stock ownership. 

For purposes of paragraph (g)(5) of this 

section, section 318(a) applies to 

determine stock ownership. Stock 

underlying a vested option is 

considered owned by the individual 

who holds the vested option (and the 

stock underlying an unvested option is 

not considered owned by the individual 

who holds the unvested option). For 

purposes of the preceding sentence, 

however, if a vested option is 

exercisable for stock that is not 

substantially vested (as defined by 

§ 1.83–3(b) and (j)), the stock underlying 

the option is not treated as owned by 

the individual who holds the option. 

(iv) Special rule for certain delayed 

payments pursuant to a change in 

control event. Compensation payable 

pursuant to the purchase by the service 

recipient of service recipient stock or a 

stock right held by a service provider, or 

payment of amounts of deferred 

compensation calculated by reference to 

the value of service recipient stock, may 

be treated as paid at a specified time or 

pursuant to a fixed schedule in 

conformity with the requirements of 

section 409A if paid on the same 

schedule and under the same terms and 

conditions as payments to shareholders 

generally pursuant to a change in 

control event described in paragraph 

(g)(5)(v) of this section (change in the 

ownership of a corporation) or as 

payments to the service recipient 

pursuant to a change in control event 

described in paragraph (g)(5)(vii) of this 

section (change in the ownership of a 

substantial portion of a corporation’s 

assets), and any amounts paid pursuant 

to such a schedule and such terms and 

conditions will not be treated as 

violating the initial or subsequent 

deferral elections rules, to the extent 

that such amounts are paid not later 

than five years after the change in 

control event. 

(v) Change in the ownership of a 

corporation—(A) In general. For 

purposes of section 409A, a change in 

the ownership of a corporation occurs 

on the date that any one person, or more 

than one person acting as a group (as 

defined in paragraph (g)(5)(v)(B) of this 

section), acquires ownership of stock of 

the corporation that, together with stock 

held by such person or group, 

constitutes more than 50 percent of the 

total fair market value or total voting 

power of the stock of such corporation. 

However, if any one person, or more 

than one person acting as a group, is 

considered to own more than 50 percent 

of the total fair market value or total 

voting power of the stock of a 

corporation, the acquisition of 

additional stock by the same person or 

persons is not considered to cause a 

change in the ownership of the 

corporation (or to cause a change in the 

effective control of the corporation 

(within the meaning of paragraph 

(g)(5)(vi) of this section)). An increase in 

the percentage of stock owned by any 

one person, or persons acting as a group, 

as a result of a transaction in which the 

corporation acquires its stock in 

exchange for property will be treated as 

an acquisition of stock for purposes of 

this section. This section applies only 

when there is a transfer of stock of a 

corporation (or issuance of stock of a 

corporation) and stock in such 

corporation remains outstanding after 

the transaction (see paragraph (g)(5)(vii) 

of this section for rules regarding the 

transfer of assets of a corporation). 

(B) Persons acting as a group. For 

purposes of paragraph (g)(5)(v)(A) of 

this section, persons will not be 

considered to be acting as a group solely 

because they purchase or own stock of 

the same corporation at the same time, 

or as a result of the same public offering. 

However, persons will be considered to 

be acting as a group if they are owners 

of a corporation that enters into a 

merger, consolidation, purchase or 

acquisition of stock, or similar business 

transaction with the corporation. If a 

person, including an entity, owns stock 

in both corporations that enter into a 

merger, consolidation, purchase or 

acquisition of stock, or similar 

transaction, such shareholder is 

considered to be acting as a group with 

other shareholders in a corporation 

prior to the transaction giving rise to the 

change and not with respect to the 

ownership interest in the other 

corporation. See § 1.280G–1, Q&A–

27(d), Example 4. 

(vi) Change in the effective control of 

a corporation—(A) In general. For 

purposes of section 409A, 

notwithstanding that a corporation has 

not undergone a change in ownership 

under paragraph (g)(5)(v) of this section, 

a change in the effective control of a 

corporation occurs only on the date that 

either—

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57979 

(1) Any one person, or more than one 

person acting as a group (as determined 

under paragraph (g)(5)(v)(B) of this 

section), acquires (or has acquired 

during the 12-month period ending on 

the date of the most recent acquisition 

by such person or persons) ownership of 

stock of the corporation possessing 35 

percent or more of the total voting 

power of the stock of such corporation; 

or 

(2) A majority of members of the 

corporation’s board of directors is 

replaced during any 12-month period by 

directors whose appointment or election 

is not endorsed by a majority of the 

members of the corporation’s board of 

directors prior to the date of the 

appointment or election, provided that 

for purposes of this paragraph 

(g)(5)(vi)(A) the term corporation refers 

solely to the relevant corporation 

identified in paragraph (g)(5)(ii) of this 

section, for which no other corporation 

is a majority shareholder for purposes of 

that paragraph (for example, if 

Corporation A is a publicly held 

corporation with no majority 

shareholder, and Corporation A is the 

majority shareholder of Corporation B, 

which is the majority shareholder of 

Corporation C, the term corporation for 

purposes of this paragraph 

(g)(5)(vi)(A)(2) would refer solely to 

Corporation A). 

(B) Multiple change in control events. 

A change in effective control also may 

occur in any transaction in which either 

of the two corporations involved in the 

transaction has a change in control 

event under paragraphs (g)(5)(v) or 

(g)(5)(vii) of this section. Thus, for 

example, assume Corporation P 

transfers more than 40 percent of the 

total gross fair market value of its assets 

to Corporation O in exchange for 35 

percent of O’s stock. P has undergone a 

change in ownership of a substantial 

portion of its assets under paragraph 

(g)(5)(vii) of this section and O has a 

change in effective control under this 

paragraph (g)(5)(vi) of this section. 

(C) Acquisition of additional control. 

If any one person, or more than one 

person acting as a group, is considered 

to effectively control a corporation 

(within the meaning of this paragraph 

(g)(5)(vi)), the acquisition of additional 

control of the corporation by the same 

person or persons is not considered to 

cause a change in the effective control 

of the corporation (or to cause a change 

in the ownership of the corporation 

within the meaning of paragraph 

(g)(5)(v) of this section). 

(D) Persons acting as a group. Persons 

will not be considered to be acting as a 

group solely because they purchase or 

own stock of the same corporation at the 

same time, or as a result of the same 

public offering. However, persons will 

be considered to be acting as a group if 

they are owners of a corporation that 

enters into a merger, consolidation, 

purchase or acquisition of stock, or 

similar business transaction with the 

corporation. If a person, including an 

entity, owns stock in both corporations 

that enter into a merger, consolidation, 

purchase or acquisition of stock, or 

similar transaction, such shareholder is 

considered to be acting as a group with 

other shareholders in a corporation only 

with respect to the ownership in that 

corporation prior to the transaction 

giving rise to the change and not with 

respect to the ownership interest in the 

other corporation. See § 1.280G–1, 

Q&A–27(d), Example 4. 

(vii) Change in the ownership of a 

substantial portion of a corporation’s 

assets—(A) In general. Change in the 

ownership of a substantial portion of a 

corporation’s assets. For purposes of 

section 409A, a change in the ownership 

of a substantial portion of a 

corporation’s assets occurs on the date 

that any one person, or more than one 

person acting as a group (as determined 

in paragraph (g)(5)(v)(B) of this section), 

acquires (or has acquired during the 12- 

month period ending on the date of the 

most recent acquisition by such person 

or persons) assets from the corporation 

that have a total gross fair market value 

equal to or more than 40 percent of the 

total gross fair market value of all of the 

assets of the corporation immediately 

prior to such acquisition or acquisitions. 

For this purpose, gross fair market value 

means the value of the assets of the 

corporation, or the value of the assets 

being disposed of, determined without 

regard to any liabilities associated with 

such assets. 

(B) Transfers to a related person—(1) 

There is no change in control event 

under this paragraph (g)(5)(vii) when 

there is a transfer to an entity that is 

controlled by the shareholders of the 

transferring corporation immediately 

after the transfer, as provided in this 

paragraph (g)(5)(vii)(B). A transfer of 

assets by a corporation is not treated as 

a change in the ownership of such assets 

if the assets are transferred to—

(i) A shareholder of the corporation 

(immediately before the asset transfer) 

in exchange for or with respect to its 

stock; 

(ii) An entity, 50 percent or more of 

the total value or voting power of which 

is owned, directly or indirectly, by the 

corporation; 

(iii) A person, or more than one 

person acting as a group, that owns, 

directly or indirectly, 50 percent or 

more of the total value or voting power 

of all the outstanding stock of the 

corporation; or 

(iv) An entity, at least 50 percent of 

the total value or voting power of which 

is owned, directly or indirectly, by a 

person described in paragraph 

(g)(5)(vii)(B)(1)(iii) of this section. 

(2) For purposes of this paragraph 

(g)(5)(vii)(B) and except as otherwise 

provided, a person’s status is 

determined immediately after the 

transfer of the assets. For example, a 

transfer to a corporation in which the 

transferor corporation has no ownership 

interest before the transaction, but 

which is a majority-owned subsidiary of 

the transferor corporation after the 

transaction is not treated as a change in 

the ownership of the assets of the 

transferor corporation. 

(C) Persons acting as a group. Persons 

will not be considered to be acting as a 

group solely because they purchase 

assets of the same corporation at the 

same time. However, persons will be 

considered to be acting as a group if 

they are owners of a corporation that 

enters into a merger, consolidation, 

purchase or acquisition of assets, or 

similar business transaction with the 

corporation. If a person, including an 

entity shareholder, owns stock in both 

corporations that enter into a merger, 

consolidation, purchase or acquisition 

of assets, or similar transaction, such 

shareholder is considered to be acting as 

a group with other shareholders in a 

corporation only to the extent of the 

ownership in that corporation prior to 

the transaction giving rise to the change 

and not with respect to the ownership 

interest in the other corporation. See 

1.280G–1, Q&A–27(d), Example 4. 

(6) Certain back-to-back 

arrangements—(i) In general. 

Notwithstanding the generally 

applicable limitations on payments 

described under paragraph (a) of this 

section, an arrangement between a 

service recipient and a service provider 

that is also a service recipient (a service 

provider/service recipient) may provide 

for payment upon the occurrence of a 

payment event described in paragraph 

(a)(1), (2), (3), (5) or (6) of this section, 

where the time and form of payment is 

defined as the same time and form of 

payment provided under an 

arrangement subject to section 409A 

between the service provider/service 

recipient and a specified service 

provider to the service provider/service 

recipient, if the arrangement between 

the service provider/service recipient 

and the service recipient expressly 

provides for such time and form of 

payment and otherwise satisfies the 

requirements of section 409A. 

57980 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

(ii) Example. The provisions of this 

paragraph (g)(6) are illustrated by the 

following example: 

Example. Company B (service provider/ 

service recipient) provides services to 

Company C (service recipient). Employee A 

(service provider) provides services to 

Company B. Pursuant to a nonqualified 

deferred compensation plan meeting the 

requirements of section 409A, Employee A is 

entitled to a payment of deferred 

compensation upon a separation from service 

from Company B. Under an arrangement 

between Company B and Company C, 

Company C agrees to pay an amount of 

deferred compensation to Company B upon 

Employee A’s separation from service from 

Company B, in accordance with the time and 

form of payment provided in the 

nonqualified deferred compensation plan 

between Employee A and Company B. 

Provided that the arrangement between 

Company B and Company C and the 

arrangement between Employee A and 

Company B otherwise comply with the 

requirements of section 409A, Company C’s 

payment to Company B of the amount due 

upon the separation from service of 

Employee A from Company B may constitute 

a permissible payment event for purposes of 

paragraph (a) of this section. 

(h) Prohibition on acceleration of 

payments—(1) In general. Except as 

provided in paragraph (h)(2) of this 

section, an arrangement that is, or 

constitutes part of, a nonqualified 

deferred compensation plan may not 

permit the acceleration of the time or 

schedule of any payment or amount 

scheduled to be paid pursuant to a 

payment under the arrangement. For 

purposes of this paragraph (h), an 

impermissible acceleration does not 

occur if payment is made in accordance 

with plan provisions or an election as to 

the time and form of payment in effect 

at the time of initial deferral (or added 

in accordance with the rules applicable 

to subsequent deferral elections under 

§ 1.409A–2(b)) pursuant to which 

payment is required to be made on an 

accelerated schedule as a result of an 

intervening event that is an event 

described in paragraph (a)(1), (2), (3), (5) 

or (6) of this section. For example, a 

plan may provide that a participant will 

receive six installment payments 

commencing at separation from service, 

and also provide that if the participant 

dies after such payments commence but 

before all payments have been made, all 

remaining amounts will be paid in a 

lump sum payment. Additionally, it is 

not an acceleration of the time or 

schedule of payment of a deferral of 

compensation if a service recipient 

waives or accelerates the satisfaction of 

a condition constituting a substantial 

risk of forfeiture applicable to such 

deferral of compensation, provided that 

the requirements of section 409A 

(including the requirement that the 

payment be made upon a permissible 

payment event) are otherwise satisfied 

with respect to such deferral of 

compensation. For example, if a 

nonqualified deferred compensation 

arrangement provides for a lump sum 

payment of the vested benefit upon 

separation from service, and the benefit 

vests under the plan only after 10 years 

of service, it is not a violation of the 

requirements of section 409A if the 

service recipient reduces the vesting 

requirement to 5 years of service, even 

if a service provider becomes vested as 

a result and receives a payment in 

connection with a separation from 

service before the service provider 

would have completed 10 years of 

service. 

(2) Exceptions—(i) Domestic relations 

order. An arrangement may permit such 

acceleration of the time or schedule of 

a payment under the arrangement to an 

individual other than the service 

provider as may be necessary to fulfill 

a domestic relations order (as defined in 

section 414(p)(1)(B)). 

(ii) Conflicts of interest. An 

arrangement may permit such 

acceleration of the time or schedule of 

a payment under the arrangement as 

may be necessary to comply with a 

certificate of divestiture (as defined in 

section 1043(b)(2)). 

(iii) Section 457 plans. An 

arrangement subject to section 457(f) 

may permit an acceleration of the time 

or schedule of a payment to a service 

provider to pay Federal, state, local and 

foreign income taxes due upon a vesting 

event, provided that the amount of such 

payment is not more than an amount 

equal to the Federal, state, local and 

foreign income tax withholding that 

would have been remitted by the 

employer if there had been a payment 

of wages equal to the income includible 

by the service provider under section 

457(f) at the time of the vesting. 

(iv) De minimis and specified 

amounts—(A) In general. An 

arrangement that does not otherwise 

provide for mandatory lump sum 

payments of benefits that do not exceed 

a specified amount may be amended to 

permit the acceleration of the time or 

schedule of a payment to a service 

provider under the arrangement, 

provided that—

(1) The payment accompanies the 

termination of the entirety of the service 

provider’s interest in the arrangement, 

and all similar arrangements that would 

constitute a nonqualified deferred 

compensation plan under § 1.409A–1(c); 

(2) The payment is made on or before 

the later of December 31 of the calendar 

year in which occurs the service 

provider’s separation from service from 

the service recipient, or the 15th day of 

the third month following the service 

provider’s separation from service from 

the service recipient; 

(3) The payment is not greater than 

$10,000; and 

(4) The participant is provided no 

election with respect to receipt of the 

lump sum payment. 

(B) Prospective deferrals. An 

amendment described in paragraph 

(h)(2)(iv)(A) of this section may be made 

with respect to previously deferred 

amounts under the arrangement as well 

as amounts to be deferred in the future. 

In addition, a nonqualified deferred 

compensation arrangement that 

otherwise complies with section 409A 

may provide, or be amended with regard 

to future deferrals to provide, that, if a 

service provider’s interest under the 

arrangement has a value below an 

amount specified by the plan at the time 

that amounts are payable under the 

plan, then the service provider’s entire 

interest under the plan must be 

distributed as a lump sum payment. 

However, once such a payment feature 

applies to an amount deferred, any 

change or elimination of such feature is 

subject to the rules governing changes in 

the time and form of payment. 

(v) Payment of employment taxes. An 

arrangement may permit the 

acceleration of the time or schedule of 

a payment to pay the Federal Insurance 

Contributions Act (FICA) tax imposed 

under section 3101, section 3121(a) and 

section 3121(v)(2), where applicable, on 

compensation deferred under the 

arrangement (the FICA Amount). 

Additionally, an arrangement may 

permit the acceleration of the time or 

schedule of a payment to pay the 

income tax at source on wages imposed 

under section 3401 or the corresponding 

withholding provisions of applicable 

state, local, or foreign tax laws as a 

result of the payment of the FICA 

Amount, and to pay the additional 

income tax at source on wages 

attributable to the pyramiding section 

3401 wages and taxes. However, the 

total payment under this acceleration 

provision must not exceed the aggregate 

of the FICA Amount, and the income tax 

withholding related to such FICA 

Amount. 

(vi) Payments upon income inclusion 

under section 409A. An arrangement 

may permit the acceleration of the time 

or schedule of a payment to a service 

provider under the plan at any time the 

arrangement fails to meet the 

requirements of section 409A and these 

regulations. Such payment may not 

exceed the amount required to be 

included in income as a result of the 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57981 

failure to comply with the requirements 

of section 409A and the regulations. 

(vii) Cancellation of deferrals 

following an unforeseeable emergency 

or hardship distribution. An 

arrangement may permit a cancellation 

of a service provider’s deferral election 

due to an unforeseeable emergency or a 

hardship distribution pursuant to 

§ 1.401(k)-1(d)(3). The deferral election 

must be cancelled, and not postponed or 

otherwise delayed, such that any later 

deferral election will be subject to the 

provisions governing initial deferral 

elections. See § 1.409A–2(a). 

(viii) Arrangement terminations. An 

arrangement may permit an acceleration 

of the time and form of a payment 

where the right to the payment arises 

due to a termination of the arrangement 

in accordance with one of the following: 

(A) The service recipient’s discretion 

under the terms of the arrangement to 

terminate the arrangement within 12 

months of a corporate dissolution taxed 

under section 331, or with the approval 

of a bankruptcy court pursuant to 11 

U.S.C. 503(b)(1)(A), provided that the 

amounts deferred under the plan are 

included in the participants’ gross 

incomes in the latest of—

(1) The calendar year in which the 

plan termination occurs; 

(2) The calendar year in which the 

amount is no longer subject to a 

substantial risk of forfeiture; or 

(3) The first calendar year in which 

the payment is administratively 

practicable. 

(B) The service recipient’s discretion 

under the terms of the arrangement to 

terminate the arrangement within the 30 

days preceding or the 12 months 

following a change in control event (as 

defined in § 1.409A–2(g)(4)(i)). For 

purposes of this paragraph (h)(2)(viii), 

an arrangement will be treated as 

terminated only if all substantially 

similar arrangements sponsored by the 

service recipient are terminated, so that 

the participant in the arrangement and 

all participants under substantially 

similar arrangements are required to 

receive all amounts of compensation 

deferred under the terminated 

arrangements within 12 months of the 

date of termination of the arrangements. 

(C) The service recipient’s discretion 

under the terms of the arrangement to 

terminate the arrangement, provided 

that—

(1) All arrangements sponsored by the 

service recipient that would be 

aggregated with any terminated 

arrangement under § 1.409A–1(c) if the 

same service provider participated in all 

of the arrangements are terminated; 

(2) No payments other than payments 

that would be payable under the terms 

of the arrangements if the termination 

had not occurred are made within 12 

months of the termination of the 

arrangements; 

(3) All payments are made within 24 

months of the termination of the 

arrangements; and 

(4) The service recipient does not 

adopt a new arrangement that would be 

aggregated with any terminated 

arrangement under § 1.409A–1(c) if the 

same service provider participated in 

both arrangements, at any time within 

five years following the date of 

termination of the arrangement. 

(D) Such other events and conditions 

as the Commissioner may prescribe in 

generally applicable guidance published 

in the Internal Revenue Bulletin (see 

§ 601.601(d)(2) of this chapter). 

(ix) Certain distributions to avoid a 

nonallocation year under section 409(p). 

An arrangement may provide for an 

acceleration of payment to prevent the 

occurrence of a nonallocation year 

(within the meaning of section 

409(p)(3)) in the plan year of the 

employee stock ownership plan next 

following the current plan year, 

provided that the amount distributed 

may not exceed 125 percent of the 

minimum amount of distribution 

necessary to avoid the occurrence of a 

nonallocation year. Solely for purposes 

of determining permissible distributions 

under this paragraph (h)(2)(ix), 

synthetic equity (within the meaning of 

section 409(p)(6)(C)) granted during the 

current employee stock ownership plan 

plan year is disregarded for purposes of 

determining whether the subsequent 

plan year would result in a 

nonallocation year. 

(3) Nonqualified deferred 

compensation arrangements linked to 

qualified plans. With respect to 

amounts deferred under an arrangement 

that is, or constitutes part of, a 

nonqualified deferred compensation 

plan, where under the terms of the 

nonqualified deferred compensation 

arrangement the amount deferred under 

the plan is the amount determined 

under the formula determining benefits 

under a qualified employer plan (as 

defined in § 1.409A–1(a)(2)) applied 

without respect to one or more 

limitations applicable to qualified 

employer plans under the Internal 

Revenue Code or other applicable law, 

or is determined as an amount offset by 

some or all of the benefits provided 

under the qualified employer plan, the 

operation of the qualified employer plan 

with respect to changes in benefit 

limitations applicable to qualified 

employer plans under the Internal 

Revenue Code or other applicable law, 

does not constitute an acceleration of a 

payment under the nonqualified 

deferred compensation arrangement 

regardless of whether such operation 

results in a decrease of amounts 

deferred under the nonqualified 

deferred compensation arrangement. In 

addition, with respect to such 

nonqualified deferred compensation 

arrangements, the following actions or 

failures to act will not constitute an 

acceleration of a payment under the 

nonqualified deferred compensation 

arrangement regardless of whether in 

accordance with the terms of the 

nonqualified deferred compensation 

arrangement, the actions or inactions 

result in a decrease in the amounts 

deferred under the arrangement: 

(i) A service provider’s action or 

inaction under the qualified employer 

plan with respect to whether to elect to 

receive a subsidized benefit or an 

ancillary benefit under the qualified 

employer plan. 

(ii) The amendment of a qualified 

employer plan to increase benefits 

provided under the qualified plan, or to 

add or remove a subsidized benefit or an 

ancillary benefit. 

(iii) A service provider’s action or 

inaction with respect to an elective 

deferral election under a qualified 

employer plan subject to section 402(g), 

including an adjustment to a deferral 

election made during a calendar year, 

provided that for any given calendar 

year, the service provider’s actions or 

inactions do not result in a decrease in 

the amounts deferred under all 

nonqualified deferred compensation 

plans in which the service provider 

participates in excess of an amount 

equal to the limit with respect to 

elective deferrals under section 402(g) 

in effect for the taxable year in which 

such action or inaction occurs. 

(iv) A service provider’s action or 

inaction under a qualified employer 

plan with respect to elective deferrals or 

after-tax contributions by the service 

provider to the qualified employer plan 

that affects the amounts that are 

credited under a nonqualified deferred 

compensation arrangement as matching 

amounts or other amounts contingent on 

service provider elective deferrals or 

after-tax contributions, provided that 

such matching or contingent amounts, 

as applicable, are either forfeited or 

never credited under the nonqualified 

deferred compensation arrangement in 

the absence of such service provider’s 

elective deferral or after-tax 

contribution, and provided further that 

for any given calendar year, the service 

provider’s actions and inactions do not 

result in a decrease in the amounts 

deferred under all nonqualified deferred 

compensation plans in which the 

57982 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

service provider participates in excess 

of an amount equal to the limit with 

respect to elective deferrals under 

section 402(g) in effect for the taxable 

year in which such action or inaction 

occurs. See § 1.409A–2(b)(6), Example 

12 and Example 13. 

§ 1.409A–4 Calculation of income inclusion. 

[Reserved]. 

§ 1.409A–5 Funding. [Reserved]. 

§ 1.409A–6 Statutory effective dates. 

(a) Statutory effective dates —(1) In 

general. Except as otherwise provided 

in this section, section 409A is effective 

with respect to amounts deferred in 

taxable years beginning after December 

31, 2004, and amounts deferred in 

taxable years beginning before January 

1, 2005, if the plan under which the 

deferral is made is materially modified 

after October 3, 2004. Section 409A is 

effective with respect to earnings on 

amounts deferred only to the extent that 

section 409A is effective with respect to 

the amounts deferred. Accordingly, 

section 409A is not effective with 

respect to earnings on amounts deferred 

before January 1, 2005, unless section 

409A is effective with respect to the 

amounts deferred. 

(2) Identification of date of deferral 

for statutory effective date purposes. For 

purposes of determining whether 

section 409A is applicable with respect 

to an amount, the amount is considered 

deferred before January 1, 2005, if before 

January 1, 2005, the service provider 

had a legally binding right to be paid the 

amount, and the right to the amount was 

earned and vested. For purposes of this 

paragraph (a)(2), a right to an amount 

was earned and vested only if the 

amount was not subject to a substantial 

risk of forfeiture (as defined in § 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 

§ 1.409A–1(b)(3)) that includes 

December 31, 2004, is not treated as 

subject to a requirement to perform 

further services (or a substantial risk of 

forfeiture) for purposes of the effective 

date. For purposes of this paragraph 

(a)(2), a stock option, stock appreciation 

right or similar compensation that on or 

before December 31, 2004, was 

immediately exercisable for cash or 

substantially vested property (as defined 

in § 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 

§ 31.3121(v)(2)–1(c)(2)(i) of this chapter) 

equals the present value as of December 

31, 2004, of the amount to which the 

service provider would be entitled 

under the plan if the service provider 

voluntarily terminated services without 

cause on December 31, 2004, and 

received a payment of the benefits with 

the maximum value available from the 

plan on the earliest possible date 

allowed under the plan to receive a 

payment of benefits following the 

termination of services. 

Notwithstanding the foregoing, for any 

subsequent calendar year, the 

grandfathered amount may increase to 

equal the present value of the benefit 

the service provider actually becomes 

entitled to, determined under the terms 

of the plan (including applicable limits 

under the Internal Revenue Code), as in 

effect on October 3, 2004, without 

regard to any further services rendered 

by the service provider after December 

31, 2004, or any other events affecting 

the amount of or the entitlement to 

benefits (other than a participant 

election with respect to the time or form 

of an available benefit). 

(ii) Account balance plans. The 

amount of compensation deferred before 

January 1, 2005, under a nonqualified 

deferred compensation plan that is an 

account balance plan (as defined in 

§ 31.3121(v)(2)–1(c)(1)(ii) of this 

chapter) equals the portion of the 

service provider’s account balance as of 

December 31, 2004, the right to which 

is earned and vested (as defined in 

paragraph (a)(2) of this section) as of 

December 31, 2004. 

(iii) Equity-based compensation 

plans. For purposes of determining the 

amounts deferred before January 1, 

2005, under an equity-based 

compensation plan, the rules of 

paragraph (a)(3)(ii) of this section 

governing account balance plans are 

applied except that the account balance 

is deemed to be the amount of the 

payment available to the service 

provider on December 31, 2004 (or that 

would be available to the service 

provider if the right were immediately 

exercisable) the right to which is earned 

and vested (as defined in paragraph 

(a)(2) of this section) as of December 31, 

2004. For this purpose, the payment 

available to the service provider 

excludes any exercise price or other 

amount that must be paid by the service 

provider. 

(iv) Earnings. Earnings on amounts 

deferred under a plan before January 1, 

2005, include only income (whether 

actual or notional) attributable to the 

amounts deferred under a plan as of 

December 31, 2004, or such income. For 

example, notional interest earned under 

the plan on amounts deferred in an 

account balance plan as of December 31, 

2004, generally will be treated as 

earnings on amounts deferred under the 

plan before January 1, 2005. Similarly, 

an increase in the amount of payment 

available pursuant to a stock option, 

stock appreciation right or other equitybased 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. 

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 57983 

(v) Definition of plan. For purposes of 

this paragraph (a), the term plan has the 

same meaning provided in § 1.409A–

1(c), except that the provisions treating 

all nonaccount balance plans under 

which compensation is deferred as a 

single plan does not apply for purposes 

of the actuarial assumptions used in 

paragraph (a)(3)(ii) of this section. 

Accordingly, different reasonable 

actuarial assumptions may be used to 

calculate the amounts deferred by a 

service provider in two different 

arrangements each of which constitutes 

a nonaccount balance plan. 

(4) Material modifications—(i) In 

general. Except as otherwise provided, a 

modification of a plan is a material 

modification if a benefit or right existing 

as of October 3, 2004, is materially 

enhanced or a new material benefit or 

right is added, and such material 

enhancement or addition affects 

amounts earned and vested before 

January 1, 2005. Such material benefit 

enhancement or addition is a material 

modification whether it occurs pursuant 

to an amendment or the service 

recipient’s exercise of discretion under 

the terms of the plan. For example, an 

amendment to a plan to add a provision 

that payments of deferred amounts 

earned and vested before January 1, 

2005, may be allowed upon request if 

service providers are required to forfeit 

20 percent of the amount of the payment 

(a haircut) would be a material 

modification to the plan. Similarly, a 

material modification would occur if a 

service recipient exercised discretion to 

accelerate vesting of a benefit under the 

plan to a date on or before December 31, 

2004. However, it is not a material 

modification for a service recipient to 

exercise discretion over the time and 

manner of payment of a benefit to the 

extent such discretion is provided under 

the terms of the plan as of October 3, 

2004. It is not a material modification 

for a service provider to exercise a right 

permitted under the plan as in effect on 

October 3, 2004. The amendment of a 

plan to bring the plan into compliance 

with the provisions of section 409A will 

not be treated as a material 

modification. However, a plan 

amendment or the exercise of discretion 

under the terms of the plan that 

materially enhances an existing benefit 

or right or adds a new material benefit 

or right will be considered a material 

modification even if the enhanced or 

added benefit would be permitted under 

section 409A. For example, the addition 

of a right to a payment upon an 

unforeseeable emergency of an amount 

earned and vested before January 1, 

2005, would be considered a material 

modification. The reduction of an 

existing benefit is not a material 

modification. For example, the removal 

of a haircut provision generally would 

not constitute a material modification. 

The establishment of or contributions to 

a trust or other arrangement from which 

benefits under the plan are to be paid is 

not a material modification of the plan, 

provided that the contribution to the 

trust or other arrangement would not 

otherwise cause an amount to be 

includible in the service provider’s 

gross income. 

(ii) Adoptions of new arrangements. It 

is presumed that the adoption of a new 

arrangement or the grant of an 

additional benefit under an existing 

arrangement after October 3, 2004, and 

before January 1, 2005, constitutes a 

material modification of a plan. 

However, the presumption may be 

rebutted by demonstrating that the 

adoption of the arrangement or grant of 

the additional benefit is consistent with 

the service recipient’s historical 

compensation practices. For example, 

the presumption that the grant of a 

discounted stock option on November 1, 

2004, is a material modification of a 

plan may be rebutted by demonstrating 

that the grant was consistent with the 

historic practice of granting 

substantially similar discounted stock 

options (both as to terms and amounts) 

each November for a significant number 

of years. Notwithstanding paragraph 

(a)(4)(i) and this paragraph (a)(4)(ii), the 

grant of an additional benefit under an 

existing arrangement that consists of a 

deferral of additional compensation not 

otherwise provided under the plan as of 

October 3, 2004, will be treated as a 

material modification of the plan only 

as to the additional deferral of 

compensation, if the plan explicitly 

identifies the additional deferral of 

compensation and provides that the 

additional deferral of compensation is 

subject to section 409A. Accordingly, 

amendments to conform a plan to the 

requirements of section 409A with 

respect to deferrals under a plan 

occurring after December 31, 2004, will 

not constitute a material modification of 

the plan with respect to amounts 

deferred that are earned and vested on 

or before December 31, 2004, provided 

that there is no concurrent material 

modification with respect to the amount 

of, or rights to, amounts deferred that 

were earned and vested on or before 

December 31, 2004. Similarly, a grant of 

an additional benefit under a new 

arrangement adopted after October 3, 

2004, and before January 1, 2005, will 

not be treated as a material modification 

of an existing plan to the extent that the 

new arrangement explicitly identifies 

additional deferrals of compensation 

and provides that the additional 

deferrals of compensation are subject to 

section 409A. 

(iii) Suspension or termination of a 

plan. A cessation of deferrals under, or 

termination of, a plan, pursuant to the 

provisions of such plan, is not a 

material modification. Amending an 

arrangement to stop future deferrals 

thereunder is not a material 

modification of the arrangement or the 

plan. Amending an arrangement to 

provide participants an election 

whether to terminate participation in a 

plan constitutes a material modification 

of the plan. 

(iv) Changes to investment 

measures—account balance plans. With 

respect to an account balance plan (as 

defined in § 31.3121(v)(2)–1(c)(1)(ii) of 

this chapter), it is not a material 

modification to change a notional 

investment measure to, or to add to 

existing investment measures, an 

investment measure that qualifies as a 

predetermined actual investment within 

the meaning of § 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 

§ 31.3121(v)(2)–1(d)(2)(i)(C) of this 

chapter). For this purpose, if with 

respect to an amount deferred for a 

period, a plan provides for a fixed rate 

of interest to be credited, and the rate is 

to be reset under the plan at a specified 

future date that is not later than the end 

of the fifth calendar year that begins 

after the beginning of the period, the 

rate is reasonable at the beginning of the 

period, and the rate is not changed 

before the reset date, then the rate will 

be treated as reasonable in all future 

periods before the reset date. 

(v) Rescission of modifications. Any 

modification to the terms of a plan that 

would inadvertently result in treatment 

as a material modification under this 

section is not considered a material 

modification of the plan to the extent 

the modification in the terms of the plan 

is rescinded by the earlier of a date 

before the right is exercised (if the 

change grants a discretionary right) or 

the last day of the calendar year during 

which such change occurred. Thus, for 

example, if a service recipient modifies 

the terms of a plan on March 1 to allow 

an election of a new change in the time 

or form of payment without realizing 

that such a change constituted a 

material modification that would 

subject the plan to the requirements of 

section 409A, and the modification is 

rescinded on November 1, then if no 

change in the time or form of payment 

has been made pursuant to the 

57984 Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / Proposed Rules 

modification before November 1, the 

plan is not considered materially 

modified under this section. 

(vi) Definition of plan. For purposes 

of this paragraph (a)(4), the term plan 

has the same meaning provided in 

§ 1.409A–1(c), except that the provision 

treating all account balance plans under 

which compensation is deferred as a 

single plan, all nonaccount balance 

plans under which compensation is 

deferred as a separate single plan, all 

separation pay arrangements due to an 

actual involuntary separation from 

service or participation in a window 

program as a separate single plan, and 

all other nonqualified deferred 

compensation plans as a separate single 

plan, does not apply. 

(b) [Reserved]. 

Mark E. Matthews, 

Deputy Commissioner of Services and 

Enforcement. 

[FR Doc. 05–19379 Filed 9–29–05; 8:45 am] 

BILLING CODE 4830–01–P