Second Opinion: New Tax Requirements for Nonqualified Deferred Compensation

Effective for the deferral of compensation after Dec. 31, 2004, the Act adds new Section 409A to the Internal Revenue Code (the “Code”). (Section 409A also applies to compensation deferred under a plan that is materially modified after Oct. 3, 2004 — the addition of any benefit, right or feature constitutes a “material modification” for this purpose.)

Section 409A is comprised of two components. First, an individual who defers compensation under an arrangement that does not satisfy the requirements of Section 409A will be currently taxable to the extent the compensation is (or when it becomes) substantially vested (ie, no deferral treatment for federal income tax purposes). In addition, the utilization of certain funding arrangements historically used in connection with nonqualified deferred compensation, specifically offshore “Rabbi Trusts” and trusts with employer financial health-related triggers, will trigger current taxation, regardless of the availability of the trust assets to address the claims of the employer's creditors.

Section 409A applies to any “nonqualified deferred compensation plan” ' any plan (including one that covers one individual only), arrangement or agreement that provides for the deferral of compensation, other than a “qualified employer plan” or bona fide vacation leave, sick leave, compensation time, disability pay or death benefit plan. For this purpose, the term “qualified employer plan” includes Code Section 401(a) tax-qualified retirement plans, Code Section 403(a) annuity plans, Code Section 415(m) governmental excess benefit arrangements, Code Section 403(b) annuity contracts, Code Section 408(k) simplified employee pensions (SEPs) and Code Section 408(p) SIMPLE plans. For this purpose, Code Section 457(b) plans of tax-exempt and governmental employers are “qualified employer plans” under Section 409A; however, Code Section 457(f) plans are not. Therefore, Code Section 457(f) plans that provide for the elective deferral of compensation are subject to Section 409A.

In general, the requirements of Section 409A are as follows:

Limitation on Distributions

Distributions must be limited to the following events ' 1) death; 2) disability (ie, where (i) the individual is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to last for a continuous period of not less than 12 months, or (ii) by reason of any medically determinable physical or mental impairment which can be expected to last for a continuous period of not less than 12 months, the individual is receiving income replacement benefits for a period of not less than 3 months under the individual's employer's accident and health plan); 3) at specified times (or per a fixed schedule) as determined at the date of the deferral of the compensation; 4) upon a change in ownership or effective control of the corporation; or 5) upon the need to meet expenses (unreimbursable by insurance or otherwise) incurred in connection with the occurrence of unforeseeable circumstances resulting from an event or events beyond the control of the participant (eg, severe financial hardship, including where resulting from sudden or unexpected illness of the participant, the participant's spouse or the participant's dependent, an accident or property loss due to casualty). In addition, a special rule for “key employees” (as defined in Code Section 416(i) ' generally, officers having annual compensation greater than $130,000 (adjusted for inflation and limited to 50 officers), 5% owners and 1% owners having annual compensation from the employer greater than $150,000) of a public company requires that they must wait for at least 6 months for a distribution on the basis of their separation from service. (Treasury Regulations are anticipated that will provide for certain exceptions, such as distributions to comply with a court-approved divorce settlement, and, under a Code Section 457(f) plan, to provide distributions for the participants to use to pay income taxes upon their becoming vested.)

No Acceleration of Distributions

Except as to be provided in Treasury regulations, there can be no acceleration of the timing of any payment or payments.

Timing of Deferral Election

An election to defer the receipt of compensation for services performed during a taxable year generally must be made during the preceding taxable year. For the first year of eligibility, a mid-year election may be made, provided that it is accomplished within 30 days of the date of initial eligibility. Existing deferral elections are permitted to be revised to delay the timing of payment or to change the payment form, provided that the election is made not less than 12 months prior to the date of a scheduled payment, cannot take effect until at least 12 month following the date of the election and, except for distributions made on account of death, disability or an unforeseeable emergency, must provide for a deferral of at least 5 years.

Funding Arrangements

Offshore “Rabbi Trusts” and trusts, the assets of which become protected from creditors (or distribute their assets to the participants) upon a change in the employer's financial health (“rabbicular” and “springing” trusts), may not be used to fund deferred compensation.

Analysis

The broad scope of Section 409A requires a diligent review of an employer's existing and proposed executive compensation arrangements. Section 409A applies to plans, arrangements and even individual agreements (or clauses therein) which provide for the deferral of compensation. It applies equally to cash and equity arrangements. An example of a widely used compensation device that will no longer be tax effective on account of Section 409A are stock appreciation rights (SARs). Prior to the effective date of the Act, the holder of an SAR was not taxed until exercise. Under the new rules, an SAR would generate immediate taxability upon grant in the amount of its intrinsic value. The same appears to be the case for certain stock options which are deemed to provide for compensation deferral, such as where a discounted exercise price is utilized, on the theory that, at exercise, the amount of the discount is compensation to the grantee, although it is not then includible (but for Section 409A) in the grantee's income. This argument can be extended to a non-discounted stock option, where, although there is no compensation upon exercise (ie, the exercise price under the option equals the fair market value of the shares underlying the option), as the underlying shares appreciate, such appreciation would arguably be deferred compensation.

As to more traditional, vanilla cash deferred compensation arrangements, those which provide for “haircut” forfeitures (ie, where the individual can receive an early distribution in exchange for a forfeiture of a predetermined (typically 10%) percentage) and/or “hardship” distributions which do not pass muster under Section 409A (eg, college expenses do not qualify as “unforeseeable”), will no longer effectively defer the receipt of compensation. However, Section 409A applies solely to deferrals occurring on or after Jan. 1, 2005; therefore, past deferrals should not be adversely affected thereby. Further, arrangements which permit distributions, deferral elections or redeferral elections which do not comply with the Section 409A requirements will similarly not be effective for federal income tax purposes, on a prospective basis.

Finally, as to funding, Section 409A precludes the use of offshore Rabbi Trusts (on the theory that they place the trust corpus out of the reach of creditors and therefore should effect taxability on the trust beneficiaries) and trusts which convert to Secular Trusts or pay out all of their assets in the event the company's financial health declines (if they are used, the individual faces immediate taxation under Code Section 83 as if he or she received a transfer of assets, increased by an additional tax in the amount of 20% of the amount of compensation required to be included in the individual's gross income, plus additional interest at the underpayment rate plus 1%). In this aspect of the new rules, in particular, the U.S. Treasury has been provided broad authority, especially in connection with offshore Rabbi Trusts, to exempt certain of such arrangements which do not result in improper deferrals or place assets beyond the reach of creditors.

Conclusion

Practitioners and employers alike will have to wait for additional Treasury guidance as to an array of important issues under Section 409A, such as the treatment of nonqualified stock options. However, for purposes of vanilla compensation deferral elections to be in place for purposes of deferring the receipt of compensation otherwise payable during 2005 and thereafter, a careful analysis of each applicable arrangement should be conducted as soon as possible, to determine whether pre-2005 changes will need to be implemented. Parties to deferred compensation arrangements should have their arrangements reviewed and evaluated by their counsel in connection with the new Code Section 409A requirements at the soonest practicable time.

In addition to or in lieu of broad-based tax-qualified retirement plans, employers often provide select executives or groups of executives with nonqualified deferred compensation arrangements. (See article by Philip Berkowitz.) These “arrangements” may be in the form of a plan, a written agreement or even a clause in an employment agreement. Much like a “401(k)” tax- qualified retirement plan, these arrangements typically provide for an advance written election by the executive to defer the receipt of otherwise payable future compensation. However, unlike tax-qualified retirement plans, which by law must generally preclude the distribution of benefits prior to an event such as death, disability, retirement or separation from service with the employer maintaining the plan, many nonqualified deferred compensation arrangements have provided for far greater flexibility as to early access to plan funds. To date, the tax law has permitted nonqualified deferred compensation, along with the attendant deferral of tax revenues for the government, on the theory that it provided a tax-favored mechanism for the accumulation of additional savings for retirement. The implementation of nonqualified deferred compensation arrangements providing for distributions upon certain types of arguably foreseeable “hardships” (eg, to pay for college) or in return for a “haircut” forfeiture, cut against the notion that the revenue deferral effect on the government is outweighed by the benefit of permitting the accumulation of additional retirement funds, as these arrangements provide benefits which may not be used for purposes of retirement.

The American Jobs Creation Act (the “Act”) was passed by the House of Representatives on Oct. 7, 2004, and received final approval from the Senate on Oct. 11, 2004. President Bush was expected to sign the Act into law before the end of 2004. The Act enumerates an array of requirements intended to curb perceived abuses in the realm of executive compensation. In many ways, the thrust of the new requirements is to conform a number of aspects of the operation of nonqualified deferred compensation arrangements to those applicable to tax-qualified “401(k)” plans. Consequently, to be tax-effective under the new requirements of the Act, deferred compensation arrangements will need to operate in a fashion more akin to true retirement arrangements.

New IRC Section 409A

Effective for the deferral of compensation after Dec. 31, 2004, the Act adds new Section 409A to the Internal Revenue Code (the “Code”). (Section 409A also applies to compensation deferred under a plan that is materially modified after Oct. 3, 2004 — the addition of any benefit, right or feature constitutes a “material modification” for this purpose.)

Section 409A is comprised of two components. First, an individual who defers compensation under an arrangement that does not satisfy the requirements of Section 409A will be currently taxable to the extent the compensation is (or when it becomes) substantially vested (ie, no deferral treatment for federal income tax purposes). In addition, the utilization of certain funding arrangements historically used in connection with nonqualified deferred compensation, specifically offshore “Rabbi Trusts” and trusts with employer financial health-related triggers, will trigger current taxation, regardless of the availability of the trust assets to address the claims of the employer's creditors.

Section 409A applies to any “nonqualified deferred compensation plan” ' any plan (including one that covers one individual only), arrangement or agreement that provides for the deferral of compensation, other than a “qualified employer plan” or bona fide vacation leave, sick leave, compensation time, disability pay or death benefit plan. For this purpose, the term “qualified employer plan” includes Code Section 401(a) tax-qualified retirement plans, Code Section 403(a) annuity plans, Code Section 415(m) governmental excess benefit arrangements, Code Section 403(b) annuity contracts, Code Section 408(k) simplified employee pensions (SEPs) and Code Section 408(p) SIMPLE plans. For this purpose, Code Section 457(b) plans of tax-exempt and governmental employers are “qualified employer plans” under Section 409A; however, Code Section 457(f) plans are not. Therefore, Code Section 457(f) plans that provide for the elective deferral of compensation are subject to Section 409A.

In general, the requirements of Section 409A are as follows:

Limitation on Distributions

Distributions must be limited to the following events ' 1) death; 2) disability (ie, where (i) the individual is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to last for a continuous period of not less than 12 months, or (ii) by reason of any medically determinable physical or mental impairment which can be expected to last for a continuous period of not less than 12 months, the individual is receiving income replacement benefits for a period of not less than 3 months under the individual's employer's accident and health plan); 3) at specified times (or per a fixed schedule) as determined at the date of the deferral of the compensation; 4) upon a change in ownership or effective control of the corporation; or 5) upon the need to meet expenses (unreimbursable by insurance or otherwise) incurred in connection with the occurrence of unforeseeable circumstances resulting from an event or events beyond the control of the participant (eg, severe financial hardship, including where resulting from sudden or unexpected illness of the participant, the participant's spouse or the participant's dependent, an accident or property loss due to casualty). In addition, a special rule for “key employees” (as defined in Code Section 416(i) ' generally, officers having annual compensation greater than $130,000 (adjusted for inflation and limited to 50 officers), 5% owners and 1% owners having annual compensation from the employer greater than $150,000) of a public company requires that they must wait for at least 6 months for a distribution on the basis of their separation from service. (Treasury Regulations are anticipated that will provide for certain exceptions, such as distributions to comply with a court-approved divorce settlement, and, under a Code Section 457(f) plan, to provide distributions for the participants to use to pay income taxes upon their becoming vested.)

No Acceleration of Distributions

Except as to be provided in Treasury regulations, there can be no acceleration of the timing of any payment or payments.

Timing of Deferral Election

An election to defer the receipt of compensation for services performed during a taxable year generally must be made during the preceding taxable year. For the first year of eligibility, a mid-year election may be made, provided that it is accomplished within 30 days of the date of initial eligibility. Existing deferral elections are permitted to be revised to delay the timing of payment or to change the payment form, provided that the election is made not less than 12 months prior to the date of a scheduled payment, cannot take effect until at least 12 month following the date of the election and, except for distributions made on account of death, disability or an unforeseeable emergency, must provide for a deferral of at least 5 years.

Funding Arrangements

Offshore “Rabbi Trusts” and trusts, the assets of which become protected from creditors (or distribute their assets to the participants) upon a change in the employer's financial health (“rabbicular” and “springing” trusts), may not be used to fund deferred compensation.

Analysis

The broad scope of Section 409A requires a diligent review of an employer's existing and proposed executive compensation arrangements. Section 409A applies to plans, arrangements and even individual agreements (or clauses therein) which provide for the deferral of compensation. It applies equally to cash and equity arrangements. An example of a widely used compensation device that will no longer be tax effective on account of Section 409A are stock appreciation rights (SARs). Prior to the effective date of the Act, the holder of an SAR was not taxed until exercise. Under the new rules, an SAR would generate immediate taxability upon grant in the amount of its intrinsic value. The same appears to be the case for certain stock options which are deemed to provide for compensation deferral, such as where a discounted exercise price is utilized, on the theory that, at exercise, the amount of the discount is compensation to the grantee, although it is not then includible (but for Section 409A) in the grantee's income. This argument can be extended to a non-discounted stock option, where, although there is no compensation upon exercise (ie, the exercise price under the option equals the fair market value of the shares underlying the option), as the underlying shares appreciate, such appreciation would arguably be deferred compensation.

As to more traditional, vanilla cash deferred compensation arrangements, those which provide for “haircut” forfeitures (ie, where the individual can receive an early distribution in exchange for a forfeiture of a predetermined (typically 10%) percentage) and/or “hardship” distributions which do not pass muster under Section 409A (eg, college expenses do not qualify as “unforeseeable”), will no longer effectively defer the receipt of compensation. However, Section 409A applies solely to deferrals occurring on or after Jan. 1, 2005; therefore, past deferrals should not be adversely affected thereby. Further, arrangements which permit distributions, deferral elections or redeferral elections which do not comply with the Section 409A requirements will similarly not be effective for federal income tax purposes, on a prospective basis.

Finally, as to funding, Section 409A precludes the use of offshore Rabbi Trusts (on the theory that they place the trust corpus out of the reach of creditors and therefore should effect taxability on the trust beneficiaries) and trusts which convert to Secular Trusts or pay out all of their assets in the event the company's financial health declines (if they are used, the individual faces immediate taxation under Code Section 83 as if he or she received a transfer of assets, increased by an additional tax in the amount of 20% of the amount of compensation required to be included in the individual's gross income, plus additional interest at the underpayment rate plus 1%). In this aspect of the new rules, in particular, the U.S. Treasury has been provided broad authority, especially in connection with offshore Rabbi Trusts, to exempt certain of such arrangements which do not result in improper deferrals or place assets beyond the reach of creditors.

Conclusion

Practitioners and employers alike will have to wait for additional Treasury guidance as to an array of important issues under Section 409A, such as the treatment of nonqualified stock options. However, for purposes of vanilla compensation deferral elections to be in place for purposes of deferring the receipt of compensation otherwise payable during 2005 and thereafter, a careful analysis of each applicable arrangement should be conducted as soon as possible, to determine whether pre-2005 changes will need to be implemented. Parties to deferred compensation arrangements should have their arrangements reviewed and evaluated by their counsel in connection with the new Code Section 409A requirements at the soonest practicable time.