Effective January 1, 2009, nonqualified deferred compensation plans must comply with final regulations under Section 409A of the Internal Revenue Code. You should review all compensation arrangements to determine if they provide for any nonqualified deferred compensation (within the meaning of Section 409A and the final regulations). If so, you should then review the nonqualified deferred compensation arrangement to determine if it complies with Section 409A and the final regulations. If you need to make any changes, you must do so by December 31, 2008.
What is deferred compensation? Under the Section 409A final regulations, deferred compensation is compensation to which an employee has a legally binding right (and not subject to a substantial risk of forfeiture) during a year that will be payable in a later year. 
What does Section 409A provide? Section 409A provides that amounts deferred under a non-qualified deferred compensation plan that does not comply in form and operation with the election, distribution, acceleration and other requirements of Section 409A are currently includible in income. In addition to recognizing income as a result of participating in a non-qualified deferred compensation plan that fails to comply with Section 409A, an employee is liable for a 20% penalty tax on the amount included in income, plus interest.
What to do now? Every employer should identify and compile a list of all compensation arrangements, including employment agreements, severance arrangements, incentive or bonus plans, stock option, stock appreciation or other equity plans, deferred compensation and other arrangements that may be subject to Section 409A. You should review them immediately to determine if they are subject to Section 409A and if they comply with the requirements of the final regulations. For all arrangements or plans that do not currently comply with Section 409A you must draft and adopt amendments that bring them into compliance.
Since Section 409A requires that deferred compensation arrangements be in writing, employers should also identify any unwritten deferred compensation arrangements and draft written documents by December 31, 2008.
Is there transition relief? Section 409A generally applies (1) to amounts deferred after December 31, 2004, and (2) to amounts deferred before January 1, 2005 if the plan was materially modified after October 3, 2004. Under IRS Notice 2007-78, until December 31, 2008, a non-qualified deferred compensation plan will be deemed to comply with Section 409A if the plan was operated in good faith compliance. In addition, the transition relief for changing the payment terms under deferred compensation plans expires on December 31, 2008. Full compliance with Section 409A and the final regulations is required by January 1, 2009.
As noted above, failure to comply with Section 409A is very costly. Employers can no longer wait to see if the Internal Revenue Service will issue a further extension for Section 409A compliance; the time to act is now.
This Compensation Alert is one in a series of ERISA and compliance-related alerts. For more information on the foregoing issues or other ERISA matters, please contact:
Copyright © 2008 Herrick, Feinstein LLP. The Compensation Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.
 Section 409A does not just apply to deferred compensation arrangements with employees but applies to arrangements with all service providers including directors and independent contractors. For example, deferred fee arrangements for investment managers may be subject to Section 409A. These arrangements should also be reviewed to insure compliance with Section 409A.