The IRS has just released Notice 2006-33, which addresses the Code Section 409A rules regarding offshore trusts and payment restrictions affecting nonqualified deferred compensation.

Background. Under Code §409A(b), a nonqualified plan: (1) may not place money used to pay plan benefits in a trust outside of the U.S.; or (2) upon a change in the employer’s financial health, may not restrict the plan assets to the payment of plan benefits. The Committee reports under Code §409A indicate that a transfer to a Rabbi Trust upon a change in the employer’s financial health would violate the latter provision. If a nonqualified plan violates Code §409A(b), at the time of the violation, the assets are considered as transferred to participants under Code §83, resulting in immediate taxation of the benefits (unless the benefits are subject to a substantial risk of forfeiture, in which case the benefits are taxable when the risk lapses). In addition, the tax is increased by an additional 20% and the participant also must pay interest at the underpayment rate plus 1%, calculated on any underpayment of tax which would have resulted had the participant included the deferred compensation in income in the year when first deferred.

Clarification of Funding Rules. The Code §409A(b) funding rules apply commencing January 1, 2005. Under the Gulf Opportunity Zone Act of 2005, Congress clarified that these funding rules apply not only to deferred compensation that is subject to Code §409A, but also to so–called “grandfathered amounts.” Grandfathered amounts are deferred compensation amounts that a participant had earned and which were vested no later than December 31, 2004. In general, such amounts are not subject to Code §409A unless the employer makes a material modification to the terms of the plan which affects the grandfathered amounts. However, as is now clear, even grandfathered amounts are subject to 409A sanctions if they are in violation of the Code §409A(b) funding rules.

Transition Relief. Notice 2006-33 describes certain amounts (“grace period assets”) which are in violation of the funding rules, but which nonetheless may be brought into compliance with the rules without triggering a 409A sanction. In general, grace period assets are amounts which on or before March 21, 2006: (i) were originally set aside in a trust outside the U.S.; (ii) were not originally set aside in an offshore trust but which were later (not after March 21, 2006) transferred outside of the U.S.; or (iii) were otherwise restricted to payment of benefits upon a change in the employer’s financial health. Such actions are in violation of Code §409A(b). However, if the violations are corrected not later than December 31, 2007, the 409A sanctions do not apply. Correction means using grace period assets to pay deferred compensation, including payment of grace period assets in connection with termination of the plan. Correction also includes taking action to sever the association between the grace period assets and the payment of the deferred compensation. Such actions include the termination of a trust which holds the assets. The plan terms also may provide for this “severance of association” occurring not later than December 31, 2007.

We are conducting a series of Code Section 409A Workshops during June and July. Notice 2006-33 will be among the many topics covered in this program. Registration will be available in early April. Check our Web site for more information.