On October 22, 2004, the President signed into law the American Jobs Creation Act of 2004 (the "Act") which, among other things, includes important new tax rules on deferred compensation. The Act's provisions are extremely broad and will significantly impact the structure of virtually every new and existing deferred compensation arrangement which may be considered to include some incentive compensation arrangements not intended, or normally considered, as compensation deferral mechanisms. Companies will need to consider these developments in implementing their overall management compensation policies, including in their 2004 bonus programs and in designing executive incentives for the coming year, and Board-level attention will likely be required for the necessary implementing actions.
The Act adds a new Section 409A to the Internal Revenue Code of 1986 (the "Code"), which provides for the inclusion in a participant's gross income of amounts deferred under nonqualified deferred compensation plans that do not meet the new requirements as well as an additional 20% tax and an interest charge thereon, Section 409A is effective for amounts deferred on and after January 1, 2005. Amounts deferred prior to January 1, 2005 are generally not subject to the new requirements, provided that no material modifications to the terms of such pre-effective date arrangements are made after October 3, 2004. Despite the January 1, 2005 effective date, some existing arrangements may be covered if aspects of the arrangements that are considered to involve deferral of income for purposes of the Act take effect after such date. The Internal Revenue Service is expected to issue later this year rules providing some guidance for dealing with these situations.
The following will outline some of the more important changes to nonqualified deferred compensation under the Act:
I. Arrangements CoveredUnder the Act
A. In General
The Act applies broadly to deferred compensation arrangements, including plans covering multiple participants and individual arrangements and agreements (including employment agreements). It appears the new rules will cover:
The new rules specifically exempt the following arrangements from coverage under the Act:
In addition, Section 409A does not apply to bonus or other compensation paid within 2 1/2 months after the close of the taxable year in which the relevant services were performed.
B. Application of the Act to Certain Stock Based Compensation
1. Stock Options
There is no express exception for stock options from treatment as a "deferral of compensation" under the Act. The Conference Report provides that the grant of stock options taxable under Section 83 of the Code is not intended to be subject to Section 409A of the Code, provided that the option does not include a deferral feature other than the option holder's right to exercise the option in the future, and further provided that the exercise price is not less than fair market value of the underlying stock on the date of grant. How the IRS will address below-market options or service will address the issues surrounding what is fair market value in the context of privately held companies is yet to be seen. The Conference Report indicates that Section 409A is not intended to affect the taxation of incentive stock options that meet the requirements of Section 422 of the Code or options granted under an employee stock purchase plan meeting the requirements of Section 423 of the Code.
2. Restricted Stock Units
Restricted stock units ("RSUs") that provide for the deferred payment of stock after vesting are covered by Section 409A. As a result participants will have much less control over the timing of the stock payment. In general, Section 409A will require any election to further defer payment to be made 12 months in advance and require the payment date to be deferred for at least 5 years from the previously scheduled payment date.
3. Stock Appreciation Rights and Phantom Stock
Preliminary indications are that the regulations under Section 409A will treat SARs and phantom stock as nonqualified deferred compensation, subject to the new rules, even if benefits are paid in stock. If this happens, then any intrinsic value in an SAR will be immediately taxable to the participant. We anticipate that the IRS will provide transition rules for outstanding SARs that remain unvested as of January 1, 2005.
II. The Act's Requirements For Deferral
A. Deferral Election
The Act contains new rules regarding the timing of deferrals. Key provisions relating to the timing of deferrals include:
B. Distribution Requirements
Under the new rules, a nonqualified deferred compensation plan must provide that compensation deferred may not be distributed earlier than:
C. Rules Affecting Acceleration of Distributions
Acceleration of payments is now generally prohibited. except for the statutory distributions noted above (disability, death, change in control, or unforeseeable emergency). This prohibition will eliminate the practice of allowing elective acceleration in the case of "haircut" provisions, which generally permitted such distributions on short notice when the executive agreed to accept a reduced amount (e.g., a 10-20% reduction). This provision would also affect the ability of a participant to elect to receive a lump sum option when the standard payment form is installments.
D. Prohibition of Certain Funding Arrangements
The new rules generally prohibit the use of foreign trusts to hold deferred compensation amounts by providing that vested participants will be immediately taxable if assets are held or transferred to a foreign trust. There is an exception for amounts held offshore where substantially all the services related to the deferrals are performed in the foreign jurisdiction where the trust resides. In addition, plans containing "financial health" triggers that segregate or restrict assets for payment of benefits in connection with changes in the employer's financial health, are prohibited.
III. Sanctions For Non-Compliance
Failure of a deferral arrangement to comply with the new rules will result in immediate taxation to each participant in the arrangement of all vested deferred compensation (including earnings on amounts deferred). In addition, the amount of tax payable by the participant on the amount subject to tax is increased by interest at the IRS underpayment rate plus 1%, measured from the date of the deferral; plus 20% of the taxable amount (i.e., an additional excise tax is imposed). A violation will result in taxation only for the participants with respect to whom the violation relates.
IV. Effective Date
The Act will apply to amounts deferred after 2004. Amounts deferred before 2005, and earnings on those amounts, generally would not be subject to the new requirements. However, a material modification of a deferral arrangement after October 3, 2004, will cause deferrals under the arrangement to be treated as post December 31, 2004 deferrals and thereby subject to the Act. The Treasury has been directed to provide a limited period during which elections to have amounts deferred after December 31, 2004 could be revoked or during which deferral arrangements could be changed to conform to the new rules.
The Conference Report indicates that an amount will be considered deferred only if it is earned and vested. However, modifying the provisions of any plan, employment contract, or other deferral arrangements, or a deferral election, to accelerate vesting prior to the effective date of the Act will not avoid the new rules. Such modification will make all deferrals under the arrangement subject to the new rules. Similarly, the Conference Report also indicates that the addition of any new benefit, right or feature is a material modification.
Treasury is directed to issue transition guidance within 60 days after enactment providing a limited period during which a deferral arrangement adopted before December 31, 2004 can be amended to either (i) provide that a participant can terminate participation in the arrangement or cancel an outstanding deferral election with respect to post-2004 deferrals, (ii) conform to the new rules with respect to post-2004 deferrals.
V. What Can Employers Do Now Pending Further Guidance?
The new rules affect all employers regardless of size, including both public and private companies, and including foreign companies that have U.S. employees. All employers must undertake a comprehensive review and potentially make fundamental changes to the design of virtually all compensation arrangements other than base salary and tax qualified plans. Employers must assess the application of Code Section 409A to stock option and other equity incentive plans, "phantom stock" and other incentive plans, supplemental retirement plans, elective deferred compensation arrangements, and severance plans. Accordingly, it is recommended that employers take the following measures pending future guidance:
Andrew L. Gaines is a Partner in the Tax Department of Weil, Gotshal & Manges LLP where he concentrates in executive compensation and employee benefit matters.