A New World for Nonqualified Deferred Compensation Plans

Failure to comply will result in harsh consequences. Generally, a participant is immediately taxed on the value of his or her deferred compensation once the benefit is no longer subject to a substantial risk of forfeiture. Additionally, the participant will have to pay a 20% excise tax on the amount that is included in his/her income, as well as an interest penalty. Thus, ignoring the new rules is not an alternative.

The Internal Revenue Service (IRS) has recently issued Notice 2005-1, providing much-needed initial guidance in a number of crucial areas.

What arrangements are subject to the new law? Under Section 409A, deferred compensation means any deferral of compensation from the year in which the related services are performed to a subsequent year. Thus, in addition to applying to traditional plans that allow executives to defer bonuses or regular pay, Section 409A may apply to a severance plan, an equity compensation plan, a long-term incentive plan and other arrangements. Examples of qualified employer plans that are exempt from the new rules include qualified retirement plans, Section 403[b] annuity plans, Section 457[b] plans, simplified employee pension plans and SIMPLE plans.

A “plan” may exist even if it covers only a single individual; it may cover any type of worker, whether an employee, an independent contractor or a partner; and it may exist even if it includes persons who are not executives or who otherwise do not fit the definition of highly compensated employees.

Short-Term Bonus Deferrals

The IRS definition of “deferred compensation” exempts certain bonus programs. For example, a short-term deferral is not subject to the new rules if it is paid by the later of 2.5 months after the tax year in which the deferral is no longer subject to forfeiture. Thus, a bonus program of a calendar year employer under which all amounts are paid to employees by March 15 (with no option for additional deferral) is not subject to the new rules.

Equity Compensation

Grants of equity compensation are generally subject to Section 409A. There are, however, certain significant exceptions:

• Incentive stock options and employee stock purchase plans. They are exempted, if they meet existing tax code rules.
• Nonstatutory stock options. A non-incentive option (also known as a nonqualified or nonstatutory option) to purchase stock of the employer is not subject to the new law if the exercise price is not less than fair market value at issuance and the option does not include any feature for the deferral of compensation other than the regular deferral of recognition of income until the exercise of the option. Because discounted options will now be subject to Section 409A deferred compensation rules, this provision increases the importance of determining the fair market value of the stock at the time an option is granted.
• Certain stock appreciation rights. One provision of the new rule may be particularly interesting to public companies. While a stock appreciation right is generally subject to new Section 409A, it will not be if: 1) the stock appreciation right exercise price is not less than the fair market value of the underlying stock on the date the right is granted; 2) the employer's stock is traded on an established securities market; 3) the stock appreciation right payment upon exercise may be settled only in stock; and 4) the right does not include any feature for the deferral of compensation (other than the deferral of recognition of income until the exercise of the right).
• Restricted stock and partnership interest. Transfers of actual shares subject to restrictions that defer tax under Code Section 83 are not subject to the new rules. In addition, until additional guidance is issued, for purposes of Section 409A, taxpayers may treat an issuance of a profits interest in connection with the performance of services as not resulting in the deferral of compensation, if not taxable under existing IRS guidance.

Severance Plans

Severance plans that provide for a deferral of any payments beyond the normal payroll period in which severance occurs may be considered deferred compensation plans. It is not yet clear whether the new rules will apply to lump sum severance payments of key employees in public companies; or, if so, such severance payments must be deferred until 6 months after the termination of employment.

The IRS has indicated that it intends to issue more detailed guidance on severance plans later in the year. However, in a limited transition relief exception, a severance plan is not required to meet Section 409A rules during calendar year 2005 if the plan is either 1) a collectively bargained plan; or 2) covers no employees who are “key employees” (generally officers earning more than $130,000 or 1% stockholders earning more than $150,000).

Special Rules

Acceleration Events

Except under circumstances specified by the IRS, a nonqualified deferred compensation plan may not permit the acceleration of payments under the plan. The new IRS notice provides limited circumstances under which payments under the plan may be accelerated, such as to meet the requirements of a domestic relations order or conflict of interest divestiture requirements. Also, a plan that does not otherwise provide for de minimis (up to $10,000) cash-out payments may be amended to permit such accelerated cash-outs.

Change in Control

The IRS notice allows a plan sponsored by a corporation (but not a partnership) to grant the corporation discretion to terminate the plan and distribute the deferred compensation within 12 months of a change in control. The guidance provides a detailed definition of change in control, under which most sales, but not most initial public offerings, will qualify.

Performance-based Compensation Rules

An election to defer “performance based compensation” may be made as late as 6 months prior to the end of the performance period. Until additional guidance is issued, the term “performance” or “bonus” compensation refers to compensation where 1) the payment of the compensation is contingent on the satisfaction of organizational or individual performance criteria; and 2) the performance criteria are not substantially certain to be met at the time a deferral election is permitted. But bonus compensation does not include any amount that will be paid regardless of performance, based upon a level of performance that is substantially certain to be met at the time the criteria is established, or that is based solely on the value of, or appreciation in value of, employer stock.

Funding. Section 409A permits the continued use of rabbi trusts for the purpose of maintaining a fund for the payment of deferred compensation. However, two specific uses of rabbi trusts are forbidden and if attempted will trigger immediate taxation of the deferred compensation along with the 20% penalty and the enhanced interest penalty: 1) use of an offshore rabbi trust; and 2) use of a “springing” rabbi trust where funding is contingent on an insolvency trigger, ie, funding that is triggered when it appears that the employer faces an increased risk of insolvency.

What does it take to be grandfathered from the new law?

Pre-2005 vested benefits are grandfathered. Section 409A is effective with respect to “amounts deferred” after Dec. 31, 2004. For purposes of Section 409A, an amount is grandfathered, ie, considered deferred before Jan. 1, 2005, if: 1) the employee has a legally binding right to be paid the amount; and 2) the right to the amount was “earned and vested” as of Dec. 31, 2004. The IRS notice provides that 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 requirement to perform future services. The notice provides that earnings on amounts deferred before Jan. 1, 2005, are grandfathered if the underlying amounts are grandfathered.

Material Modifications

Even if an amount is “earned and vested,” Section 409A also applies to amounts deferred before 2005 if the plan under which the deferral is made is “materially modified” after Oct. 3, 2004. A plan is materially modified if it adds a new benefit even if that new benefit is one that is permitted by Section 409A (eg, adding a hardship distribution). A plan is not materially amended if it is modified to conform to Section 409A without adding new benefits or if it eliminates future deferrals. Also, it is not a material modification to change or add an investment measure.

What transition relief is available for prior deferral elections and for future needed plan amendments? IRS Notice 2005-1 provides transitional relief in several areas.

• Current compensation deferral elections under pre-existing plans. Elections for deferring 2005 compensation may be made any time prior to March 15, 2005 (as opposed to the normal rule of Dec. 31, 2004). Elections can be effective, however, only for compensation payable after the election is made.
• Plan amendments and operational compliance. A plan will not be treated as violating Section 409A if: 1) the plan is operated in accordance with a good faith, reasonable interpretation of Section 409A and IRS Notice 2005-1; and 2) the plan is amended on or before Dec. 31, 2005, to conform to the provisions of Section 409A with respect to non-grandfathered amounts (eg, non-vested prior deferrals] subject to the new rules. To operate in good faith compliance, neither the plan sponsor nor a participant may exercise discretion under the terms of the plan in a manner that causes the plan to fail to meet the requirements of Section 409A.

Some plan sponsors may wish for the sake of uniformity of administration to amend even grandfathered plans to comply with new Section 409A. If, however, the plan is not operated in compliance with the new rules after Jan. 1, 2005, the sponsor will be unable subsequently to amend the plan document into compliance.

Plan Terminations

After this year, it will be virtually impossible to terminate plans until all benefits have been paid in accordance with the originally elected payment dates. However, IRS Notice 2005-1 permits plans to be terminated, and benefits distributed, by Dec. 31, 2005. Termination is something to consider if you have frozen plans, plans with small accounts, or plans you have no interest in maintaining under the new rules.

Plan amendments to permit participant changes. Transition rules allow an employer to amend an existing plan to permit participants to make changes in their prior elections during all of 2005 even though such changes would otherwise violate Section 409A. Amending existing plans to permit a change in the form or timing of a benefit payment, to permit a participant to opt out and take the entire value of his or her benefit into income, or to terminate an existing deferral election will not be considered to be a material modification.

The IRS has promised additional guidance in the upcoming months. But in light of the current guidance, companies and participants should act now to consider transition actions to comply with the new law.

(See article by Dana Scott Fried for an additional viewpoint on this issue.)

Employment lawyers have been inundated in the last few weeks with calls from clients asking how and whether the new American Jobs Creation Act affects various severance pay plans and other deferred compensation plans. If you are still recovering from the recent presidential election, or are preoccupied by the pending elections in Iraq, this one may have slipped by you. The smart thing to do would be to consult your benefits partner, as I did. In this article, I explain this new law in layman's terms and help you respond to those callers clamoring for information about this creatively titled statute.

In October 2004, Congress enacted new Internal Revenue Code Section 409A, a creature of the Jobs Creation Act. According to those who know, this is nothing less than the most comprehensive regulation of nonqualified deferred compensation plans ever enacted.

In brief, new Section 409A:

• Limits flexibility in the timing of elections to defer compensation;
• Restricts distributions while employed to fixed dates, certain changes of control, or extreme financial hardship;
• Requires distributions to key executives of public companies to be delayed for six months after termination of employment;
• Precludes acceleration of distribution dates;
• Effectively bars most trusts located offshore or that contain financial triggers; and
• Prevents deferrals of distribution dates unless made at least 1 year in advance and the new distribution date is at least 5 years after the prior distribution date.

Consequences of Noncompliance

Failure to comply will result in harsh consequences. Generally, a participant is immediately taxed on the value of his or her deferred compensation once the benefit is no longer subject to a substantial risk of forfeiture. Additionally, the participant will have to pay a 20% excise tax on the amount that is included in his/her income, as well as an interest penalty. Thus, ignoring the new rules is not an alternative.

The Internal Revenue Service (IRS) has recently issued Notice 2005-1, providing much-needed initial guidance in a number of crucial areas.

What arrangements are subject to the new law? Under Section 409A, deferred compensation means any deferral of compensation from the year in which the related services are performed to a subsequent year. Thus, in addition to applying to traditional plans that allow executives to defer bonuses or regular pay, Section 409A may apply to a severance plan, an equity compensation plan, a long-term incentive plan and other arrangements. Examples of qualified employer plans that are exempt from the new rules include qualified retirement plans, Section 403[b] annuity plans, Section 457[b] plans, simplified employee pension plans and SIMPLE plans.

A “plan” may exist even if it covers only a single individual; it may cover any type of worker, whether an employee, an independent contractor or a partner; and it may exist even if it includes persons who are not executives or who otherwise do not fit the definition of highly compensated employees.

Short-Term Bonus Deferrals

The IRS definition of “deferred compensation” exempts certain bonus programs. For example, a short-term deferral is not subject to the new rules if it is paid by the later of 2.5 months after the tax year in which the deferral is no longer subject to forfeiture. Thus, a bonus program of a calendar year employer under which all amounts are paid to employees by March 15 (with no option for additional deferral) is not subject to the new rules.

Equity Compensation

Grants of equity compensation are generally subject to Section 409A. There are, however, certain significant exceptions:

• Incentive stock options and employee stock purchase plans. They are exempted, if they meet existing tax code rules.
• Nonstatutory stock options. A non-incentive option (also known as a nonqualified or nonstatutory option) to purchase stock of the employer is not subject to the new law if the exercise price is not less than fair market value at issuance and the option does not include any feature for the deferral of compensation other than the regular deferral of recognition of income until the exercise of the option. Because discounted options will now be subject to Section 409A deferred compensation rules, this provision increases the importance of determining the fair market value of the stock at the time an option is granted.
• Certain stock appreciation rights. One provision of the new rule may be particularly interesting to public companies. While a stock appreciation right is generally subject to new Section 409A, it will not be if: 1) the stock appreciation right exercise price is not less than the fair market value of the underlying stock on the date the right is granted; 2) the employer's stock is traded on an established securities market; 3) the stock appreciation right payment upon exercise may be settled only in stock; and 4) the right does not include any feature for the deferral of compensation (other than the deferral of recognition of income until the exercise of the right).
• Restricted stock and partnership interest. Transfers of actual shares subject to restrictions that defer tax under Code Section 83 are not subject to the new rules. In addition, until additional guidance is issued, for purposes of Section 409A, taxpayers may treat an issuance of a profits interest in connection with the performance of services as not resulting in the deferral of compensation, if not taxable under existing IRS guidance.

Severance Plans

Severance plans that provide for a deferral of any payments beyond the normal payroll period in which severance occurs may be considered deferred compensation plans. It is not yet clear whether the new rules will apply to lump sum severance payments of key employees in public companies; or, if so, such severance payments must be deferred until 6 months after the termination of employment.

The IRS has indicated that it intends to issue more detailed guidance on severance plans later in the year. However, in a limited transition relief exception, a severance plan is not required to meet Section 409A rules during calendar year 2005 if the plan is either 1) a collectively bargained plan; or 2) covers no employees who are “key employees” (generally officers earning more than $130,000 or 1% stockholders earning more than $150,000).

Special Rules

Acceleration Events

Except under circumstances specified by the IRS, a nonqualified deferred compensation plan may not permit the acceleration of payments under the plan. The new IRS notice provides limited circumstances under which payments under the plan may be accelerated, such as to meet the requirements of a domestic relations order or conflict of interest divestiture requirements. Also, a plan that does not otherwise provide for de minimis (up to $10,000) cash-out payments may be amended to permit such accelerated cash-outs.

Change in Control

The IRS notice allows a plan sponsored by a corporation (but not a partnership) to grant the corporation discretion to terminate the plan and distribute the deferred compensation within 12 months of a change in control. The guidance provides a detailed definition of change in control, under which most sales, but not most initial public offerings, will qualify.

Performance-based Compensation Rules

An election to defer “performance based compensation” may be made as late as 6 months prior to the end of the performance period. Until additional guidance is issued, the term “performance” or “bonus” compensation refers to compensation where 1) the payment of the compensation is contingent on the satisfaction of organizational or individual performance criteria; and 2) the performance criteria are not substantially certain to be met at the time a deferral election is permitted. But bonus compensation does not include any amount that will be paid regardless of performance, based upon a level of performance that is substantially certain to be met at the time the criteria is established, or that is based solely on the value of, or appreciation in value of, employer stock.

Funding. Section 409A permits the continued use of rabbi trusts for the purpose of maintaining a fund for the payment of deferred compensation. However, two specific uses of rabbi trusts are forbidden and if attempted will trigger immediate taxation of the deferred compensation along with the 20% penalty and the enhanced interest penalty: 1) use of an offshore rabbi trust; and 2) use of a “springing” rabbi trust where funding is contingent on an insolvency trigger, ie, funding that is triggered when it appears that the employer faces an increased risk of insolvency.

What does it take to be grandfathered from the new law?

Pre-2005 vested benefits are grandfathered. Section 409A is effective with respect to “amounts deferred” after Dec. 31, 2004. For purposes of Section 409A, an amount is grandfathered, ie, considered deferred before Jan. 1, 2005, if: 1) the employee has a legally binding right to be paid the amount; and 2) the right to the amount was “earned and vested” as of Dec. 31, 2004. The IRS notice provides that 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 requirement to perform future services. The notice provides that earnings on amounts deferred before Jan. 1, 2005, are grandfathered if the underlying amounts are grandfathered.

Material Modifications

Even if an amount is “earned and vested,” Section 409A also applies to amounts deferred before 2005 if the plan under which the deferral is made is “materially modified” after Oct. 3, 2004. A plan is materially modified if it adds a new benefit even if that new benefit is one that is permitted by Section 409A (eg, adding a hardship distribution). A plan is not materially amended if it is modified to conform to Section 409A without adding new benefits or if it eliminates future deferrals. Also, it is not a material modification to change or add an investment measure.

What transition relief is available for prior deferral elections and for future needed plan amendments? IRS Notice 2005-1 provides transitional relief in several areas.

• Current compensation deferral elections under pre-existing plans. Elections for deferring 2005 compensation may be made any time prior to March 15, 2005 (as opposed to the normal rule of Dec. 31, 2004). Elections can be effective, however, only for compensation payable after the election is made.
• Plan amendments and operational compliance. A plan will not be treated as violating Section 409A if: 1) the plan is operated in accordance with a good faith, reasonable interpretation of Section 409A and IRS Notice 2005-1; and 2) the plan is amended on or before Dec. 31, 2005, to conform to the provisions of Section 409A with respect to non-grandfathered amounts (eg, non-vested prior deferrals] subject to the new rules. To operate in good faith compliance, neither the plan sponsor nor a participant may exercise discretion under the terms of the plan in a manner that causes the plan to fail to meet the requirements of Section 409A.

Some plan sponsors may wish for the sake of uniformity of administration to amend even grandfathered plans to comply with new Section 409A. If, however, the plan is not operated in compliance with the new rules after Jan. 1, 2005, the sponsor will be unable subsequently to amend the plan document into compliance.

Plan Terminations

After this year, it will be virtually impossible to terminate plans until all benefits have been paid in accordance with the originally elected payment dates. However, IRS Notice 2005-1 permits plans to be terminated, and benefits distributed, by Dec. 31, 2005. Termination is something to consider if you have frozen plans, plans with small accounts, or plans you have no interest in maintaining under the new rules.

Plan amendments to permit participant changes. Transition rules allow an employer to amend an existing plan to permit participants to make changes in their prior elections during all of 2005 even though such changes would otherwise violate Section 409A. Amending existing plans to permit a change in the form or timing of a benefit payment, to permit a participant to opt out and take the entire value of his or her benefit into income, or to terminate an existing deferral election will not be considered to be a material modification.

The IRS has promised additional guidance in the upcoming months. But in light of the current guidance, companies and participants should act now to consider transition actions to comply with the new law.

(See article by Dana Scott Fried for an additional viewpoint on this issue.)