On December 20, 2004, the Treasury Department and the Internal Revenue Service issued Notice 2005-1, which provides initial guidance under Section 409A of the Internal Revenue Code. Section 409A, enacted as part of the American Jobs Creation Act of 2004, makes sweeping changes to the rules governing nonqualified deferred compensation. The initial guidance focuses primarily on definitional issues and transition rules, leaving many questions to future guidance. Future guidance that is more restrictive will be prospective only and taxpayers may rely on the initial guidance for now.
Plans subject to the new law need to be in good-faith operational compliance with the new law beginning on January 1, 2005. As a result, companies will need to give prompt attention to the impact of the guidance on their compensation arrangements.
This article provides an overview of the principal issues addressed by the initial guidance.
Purpose Of Section 409A
Section 409A provides specific rules for nonqualified deferred compensation plans relating to deferral elections, distributions, funding and acceleration of benefits. Failure to comply with Section 409A generally results in immediate income inclusion of the amounts deferred, plus a 20% penalty tax.
Definition Of "NonqualifiedDeferred Compensation Plan"
A nonqualified deferred compensation plan is any "plan" that provides for the "deferral of compensation." A "plan" is any agreement, method or arrangement, written or otherwise, between a company and one or more "service providers,"1 which includes employees and partners in a partnership, as well as other nonemployee service providers.
"Plans" include: "account balance plans" ( e.g. , typical elective deferred compensation plans), "nonaccount balance plans" ( e.g. , defined benefit SERPs) and other plans ( e.g. , stock option and stock appreciation right ("SAR") plans). The statutory requirements are applied to each category of plan separately, and within each category (i) a separate plan (or plans) is deemed maintained for each participant and (ii) all compensation deferred with respect to a particular participant is treated as deferred under a single plan, ensuring that operational violations relating to one participant will not affect the deferrals of other participants. This also means, however, that a violation with respect to a participant in one plan category will disqualify that participant's deferrals under all employer plans in the same category (other than plans that are grandfathered), including such prior deferrals. Consequently, a participant's prior deferrals under a specific plan category cannot be protected by implementing new, separate plans each year.
Exempted plans include qualified retirement plans under Code Section 401(a), tax-deferred annuities, simplified employee pension plans, SIMPLE plans, and eligible deferred compensation plans under Code Section 457(b), along with certain welfare benefit plans including bona fide vacation, sick leave, compensatory time, disability pay and death benefit plans.
Deferral Of Compensation
A nonqualified deferred compensation plan provides for a "deferral of compensation" only if a service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and is payable to the service provider in a later year, whether by design or voluntary election. A deferral of compensation does not occur when the compensation must (by the terms of the plan) be paid within 2 1/2 months after the end of the first taxable year of the employer or employee (whichever ends later) in which it is no longer subject to a "substantial risk of forfeiture."
Non-qualified stock options2 are considered deferred compensation unless (i) the exercise price is not less than the fair market value of the underlying stock on the date of grant and (ii) the option does not contain a separate feature for deferral of compensation. The grant of a contractual right to receive stock at a future date (such as a restricted stock unit or "RSU") will be treated as a deferral of compensation, but the issuance of stock subject to vesting (restricted stock) will not.
The issuance of a profits interest in a partnership in exchange for services that does not result in income inclusion at the time of issuance under existing law will not be treated as a deferral of compensation.
Substantial Risk Of Forfeiture
Compensation is subject to a substantial risk of forfeiture if entitlement to the compensation is conditioned upon (i) the performance of substantial future services or (ii) the occurrence of a condition related to a purpose of the compensation , and (in either case) the possibility of forfeiture is substantial. A condition is related to the purpose of the compensation if it relates to a service provider's individual performance, or the employer's business activities or organizational goals. Examples include individual, strategic or company performance goals, and liquidity events, such as an IPO or sale of the employer. The possibility of forfeiture may be considered insubstantial where an employee owns a significant percentage of an employer's voting securities and can assert effective control over the employer, making enforcement unlikely, or when payment is conditioned upon compliance with a restrictive covenant, e.g. , a noncompete provision.
Change In Control
Deferred compensation must be distributable only upon one or more permissible events, which may include a change in control of the corporation maintaining the plan. The initial guidance defines change in control in a manner similar to the definition used for purposes of the golden parachute rules under Section 280G of the Code.
Accelerating Payment Of Deferred Compensation
Acceleration of the time or schedule of any payment under a nonqualified deferred compensation plan is generally prohibited. Exceptions are made for payments upon a change in control or in connection with an unforeseeable emergency, to comply with a domestic relations order or a certificate of divestiture, to address a conflict of interest, or to pay employment taxes.
Section 409A applies to (i) compensation deferred in taxable years beginning after December 31, 2004 and (ii) compensation deferred in taxable years prior to January 1, 2005 if the plan under which the deferral is made is materially modified after October 3, 2004 or the deferred amounts are not earned and vested prior to January 1, 2005. An amount is considered earned and vested only if it is not subject to a substantial risk of forfeiture or a requirement to perform further services. Amounts previously deferred and not subject to Section 409A are grandfathered. Section 409A does not apply to earnings on grandfathered amounts.
Material ModificationOf Grandfathered Plans
A grandfathered plan or award is materially modified if a benefit or right existing under the plan or award as of October 3, 2004 is enhanced or a new benefit or right is added, e.g. , adding a feature to accelerate vesting. Conversely, it is not a material modification for an employer to (i) exercise discretion over the time and manner of benefit payments if such discretion is permitted under the plan as of October 3, 2004; (ii) amend a grandfathered plan to stop future deferrals; or (iii) terminate a grandfathered plan on or before December 31, 2005 and distribute all deferred amounts, provided that such amounts are included in the participant's income in the same year in which the plan is terminated. Also, it is not a material modification for a participant to exercise a right permitted under any such plan.
The cancellation on or before December 31, 2005 of an outstanding SAR or discount stock option that is subject to Section 409A, in exchange for a replacement grant that is statutorily exempt, will not be a material modification, provided (i) the number of shares subject to both grants are the same and (ii) the new grant does not provide any additional benefits.
Nongrandfathered Plans Adopted On Or Before December 31, 2005
Plans adopted on or before December 31, 2005 that are not grandfathered must be maintained in good-faith operational compliance during 2005, and such plans must be brought into full compliance on or before December 31, 2005.
A plan is maintained in good-faith operational compliance if it is administered in accordance with the initial guidance. For operational issues not yet addressed, the plan must be operated in compliance with Section 409A based on a good-faith, reasonable interpretation of the statute and its legislative history.
Allowing Participants To Terminate Participation Or Cancel An Outstanding Deferral Election
A plan adopted on or before December 31, 2005 may be amended to allow a participant, on or before December 31, 2005, to terminate participation or cancel an outstanding deferral election provided these amounts are includible in the participant's income for 2005 or, if later, the taxable year in which the amounts are earned and vested.
Making Deferral Elections For 2004 And 2005 Compensation
Deferral elections that relate to compensation for services to be performed on or prior to December 31, 2005 may be made on or prior to March 15, 2005, provided (i) the amounts to which the deferral elections relate were not paid or payable at the time of the election, (ii) the plan under which the elections are made existed on or before December 31, 2004, (iii) the elections are pursuant to the plan's terms as in effect on or before December 31, 2004, (iv) the plan is otherwise operated in accordance with the statute and (v) the plan is amended to statutorily comply by December 31, 2005.
Deferring Annual Bonuses For 2005
Although deferral elections generally must be made prior to the beginning of the year in which the compensation is earned, an exception is made for compensation that is "performance-based" and payable for services to be performed over at least a 12-month period, e.g. , annual bonus compensation. Such elections may be made no later than six months before the end of the year to which the bonus relates. For 2005, compensation will be treated as "performance-based" if it is contingent on the satisfaction of organizational or individual performance criteria, where the performance criteria are not substantially certain to be met at the time the deferral election is made.
New Reporting And Withholding Requirements
Beginning with compensation deferred for 2005, all deferrals under a nonqualified deferred compensation plan must be reported on Forms W-2 and 1099, respectively, for the year in which the amount is actually deferred. Amounts are actually deferred in the year in which the service provider first has a legally binding right to the compensation, so reporting for 2005 deferrals will be required as early as 2006. All such amounts are considered wages subject to income tax withholding.
1 Section 409A is inapplicable to service providers actively engaged in a trade or business providing services (other than as an employee or director) to two or more unrelated third parties, thus excluding fee arrangements between consulting, accounting and law firms, and clients of such firms.
2 Statutory stock options within the meaning of Code Sections 422 or 423 do not provide for a deferral of compensation .
Stephen T. Lindo and Frank A. Daniele are Partners in the Executive Compensation and Employee Benefits Department in the New York office of Willkie Farr & Gallagher LLP.