Health and Welfare Benefit Reminders Please keep in mind that the Medicare Part D enrollment period is already underway, and group health plans that offer prescription drug coverage to Medicare-eligible employees or retirees, must provide notices of creditable coverage to those individuals. Plan sponsors that filed for a Part D subsidy should be making efforts towards putting the required acknowledgments and plan sponsor agreements in place if not done so already. See our September 2005 Alert for details. Also, the year-end compliance deadline related to the HIPAA Portability Regulations is rapidly approaching for calendar year plans. See our March 28, 2005 Alert for details. Feel free to call us for Medicare Part D and HIPAA compliance assistance. Automatic Rollover Requirements As we alerted you in January 2005, the company's qualified plans need to be amended for the new automatic rollover requirements by December 31, 2005. Please let us know as soon as possible if you still need amendments or if you have amended the plans. You may have received an amendment from your prototype 401(k) plan sponsor. If so, please send us a copy of the amendment for our review. Deadline for Deferring Bonuses If an employee wishes to defer a bonus (other than a performance-based bonus) earned in 2006 and payable early in 2007, the deferral election, and the form and time of payment of such deferred bonus, must be made no later than December 31, 2005. If the bonus is performance-based, as defined in Internal Revenue Service proposed regulations, during calendar year 2006, the deferral election can be made as late as June 30, 2006. Please contact us if you wish assistance with forms for making these elections.

As we have previously informed you, proposed regulations under Code Section 409A were issued on September 29, 2005 that supplement guidance in IRS Notice 2005-1 issued last December. Some of the issues raised by the regulations include the following:

1. The regulations permit a participant to make an initial "evergreen" deferral election that remains in effect until terminated or modified by the participant. Such an election should expressly provide that as of each December 31 the deferral election becomes irrevocable with respect to compensation payable for services performed in the immediately following year. The irrevocability should not, however, extend to the time and form of the payment of the deferred compensation, so the participant can have the flexibility to later change those elections (in accordance with 409A).
   
   
2. Generally, a bonus paid within 2½ months after the year in which it is earned is not subject to 409A. The 409A regulations provide that while this payment deadline is not required to be in writing, the absence of a written provision results in an automatic violation of 409A in the case of a late payment that is made after this deadline. If the deadline is expressed in writing and it is missed, a company can still have 409A compliance if the payment is made any time by the end of the year in which payment should have been made. The document that suffices as the company's bonus plan should be amended, if necessary to include this payment deadline.
   
   
3. The proposed regulations include an "ad hoc" rule addressing initial deferral elections of nonqualified deferred compensation granted during a taxable year. This is especially important where the grant was unforeseeable at the beginning of the year, thus making it difficult to make elections before the beginning of the year. The rule provides that where a grant of 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 can be made no later than 30 days after the date of grant, provided the election is made at least 12 months before the end of the forfeiture period. Thus, for example, a mid-year stock grant to a newly-elected director can be subject to a deferral election made within 30 days after the date of grant, provided the grant is subject to a risk of forfeiture for at least 12 months after the date of the election. If the deferral election is made prior to the grant, the 12-month forfeiture period can start as of the grant date. If the election is made within 30 days after the grant, the forfeiture period must be 13 months in order to give the recipient the full 30 days to make the election.
   
   
4. The proposed regulations provide that a stock option with an exercise price equal to the fair market value of the underlying stock at the date of grant will not be subject to 409A. An extension of the option exercise period beyond the later of the 15th day of the third month following, or December 31 of the calendar year of, the original exercise expiration date, will be treated as an additional deferral feature, meaning that the stock option was subject to 409A from the date of the initial grant. This will cause a problem if the original exercise period is extended, but the original exercise price is retained. If the original exercise price is less than the fair market value of the stock at the date of the extension, the option is subject to 409A and requires a fixed time for exercise.
   
   
5. The Notice indicated that a tandem arrangement involving stock options and stock appreciation rights would constitute a deferral of compensation subject to 409A. The proposed regulations do not specifically address tandem stock options and stock appreciation rights. The regulations do provide that a stock option or a stock appreciation right with an exercise price equal to the fair market value of the underlying stock at the date of grant is not subject to 409A. Presumably, a tandem grant with the fair market value of the underlying stock at the date of grant applying to both the stock option and the stock appreciation right is excluded from 409A coverage.
   
   
6. The regulations include guidance on the definition of performance-based compensation with respect to which an extra six month deferral period is available. Notwithstanding this guidance, clients may not be able to specifically determine in advance whether the bonus criteria will meet the performance-based standard. In addition, in many cases if the performance-based criteria are not satisfied, the employer still retains the ability to pay discretionary bonuses. Accordingly, it would be conservative to require an executive to make a deferral election with respect to a discretionary bonus in the year prior to the year in which the bonus is earned and permit an additional six month deferral period if it is determined that the bonus is performance-based.
   
   
7. Often a plan will provide that payments of deferred compensation be made or commence "as soon as practicable" after the designated date for payment (such as separation from service) occurs. Under the regulations, a payment will be treated as made upon the designated date if it 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). If a plan or arrangement uses the "administratively feasible" approach in lieu of the "as soon as practicable" approach, it should include qualifying language set forth in the regulations.
   
   
8. The regulations extend until December 31, 2006, the deadline by which to amend plan documents. However, the regulations did not extend two transitional items provided in the Notice: (i) a participant's ability to make an election by March 15, 2005 to defer compensation earned in 2005 and (ii) a participant's ability to elect during 2005 to terminate plan participation or cancel a deferral election, in each case as long as the plan was amended by December 31, 2005 to reflect this transitional relief. Because the regulations did not extend the deadlines for making these elections, it is unclear whether a plan still must be amended by the end of 2005 in connection with these 2005 elections. Some clients have taken a conservative approach and amended their plans by the end of 2005 to reflect these transitional elections.
   
   
9. The Notice permits a nonqualified plan to tie its time and form elections to those made under a related qualified plan. The regulations extended this relief from December 31, 2005 to December 31, 2006. The regulations also contain a transition rule allowing a participant to make a time or form election during 2006 without regard to Section 409A so long as the election does not accelerate income into 2006 or postpone beyond 2006 income that would otherwise be recognized in 2006. It is unclear whether a nonqualified plan that remains tied to a qualified plan during 2006 can also permit a participant to make the special 2006 time or form election. A conservative approach suggests not allowing the use of the special time and form election under a nonqualified plan that remains tied during 2006.
   
   
10. The proposed regulations include rules relating to arrangements with independent contractors. A grant to a nonqualified director is subject to 409A. However, 409A will not generally apply to amounts deferred pursuant to an arrangement between the service recipient and an unrelated independent contractor (other than a director) 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.

The above is only a partial list of issues continuing to exist under Code Section 409A, but include some of the most practical considerations that arise as plans and arrangements are revised to comply with 409A. 

A recent Seventh Circuit decision serves as a valuable reminder of the importance of including "safe harbor" language in plan documents in order to avoid unnecessary litigation over benefits decisions and the related standard of review. In Diaz v. Prudential Insurance Co. of America, the Seventh Circuit held that even though the plan at issue included some language regarding employer discretion related to benefits decisions, it simply did not go far enough. In order to largely insulate a plan administrator's decision from judicial scrutiny, a plan must contain proper language conferring discretion on the plan administrator. In its decision, the Seventh Circuit once again endorsed the following language: "Benefits under this plan will be paid only if the plan administrator decides in his discretion that the applicant is entitled to them." Only this language, or other language which clearly signals discretion on the part of the plan administrator, will suffice. If sufficient language is present, a Seventh Circuit court will uphold a reasonable plan administrator decision, even if the court would decide the question differently if it did not give deference to the plan administrator's decision.

At issue in Diaz was a plan administrator's decision to deny the plaintiff, Hugo Diaz, long-term disability benefits. Mr. Diaz worked for two years as a computer programmer before complaining of persistent back pain. He was subsequently diagnosed with degenerative disc disease and eventually underwent surgery. Following surgery, Mr. Diaz continued to report varying levels of pain. Mr. Diaz decided that he was unable to return to work and on July 22, 2002 filed for long-term disability benefits. Prudential, the plan's insurer, denied the claim based on its conclusion that Diaz's reported inability to perform his job (which it considered a sedentary one) was not consistent with the medical evidence. Mr. Diaz appealed the rejection of benefits numerous times, but his claim was consistently denied.

Two sections of the plan were vital in determining whether the plan administrator's decision to deny benefits was entitled to judicial deference. The first section at issue was titled "How does Prudential Define Disability?" and stated "[y]ou are disabled when Prudential determines that: you are unable to perform the material and substantial duties of your regular occupation due to your sickness or injury and you have 20% or more loss in your indexed monthly earnings due to sickness or injury." The second section, titled "Long Term Disability Coverage-Claim Information," stated "[w]e may request that you send proof of continuing disability, satisfactory to Prudential, indicating that you are under the regular care of a doctor." The district court concluded that, taken together, the two sections signaled to the employee that Prudential had discretion to determine eligibility for benefits.

Two earlier decisions by the Seventh Circuit appeared to support the district court's conclusion. In Donato v. Metropolitan Life Insurance Co. and Bali v. Blue Cross & Blue Shield Ass'n, the court held that language including a phrase stating that disability payments would be paid upon evidence "satisfactory to us [the plan administrator]" was adequate to signal discretion by a plan administrator to deny benefits. In addition, decisions from several other Circuits also noted that plan language noting that the proof must be "satisfactory" to the plan administrator was sufficient language to signal discretion.

In Diaz, however, the Seventh Circuit clarified that in order to provide discretion, plan language must communicate the idea that the administrator "not only has broad-ranging authority to assess compliance with pre-existing criteria, but also has the power to interpret the rules, to implement the rules, and even to change them entirely." The court further stated that no single phrase, such as "satisfactory to us" is sufficient to convey that the administrator has been given complete discretion. In order to attain judicial deference, plan language must give the participant notice that the plan administrator has discretion to determine benefit eligibility. The safe-harbor language quoted above, adapted as necessary to the facts and circumstances at hand, will suffice for this purpose.

Establishing a favorable standard of review is an effective tool that a plan administrator should use to provide a measure of protection to its decisions. You should contact a member of the Schiff Hardin Employee Benefits and Executive Compensation Group for assistance in ensuring that plan administrator decisions will be entitled to the maximum deference possible. 

The IRS issued the cost-of-living adjustments applicable to dollar limitations for employee pension benefit plans for the 2006 tax year. Effective January 1, 2006, the limits are as indicated below.