Nonqualified Deferred Compensation Impacted By Code Section 409A

The recently enacted American Jobs Creation Act of 2004 ("AJCA") requires all nonqualified deferred compensation plans ("NDCPs") to contain certain restrictions on deferral elections and distributions. AJCA added Internal Revenue Code ("Code") Section 409A, which provides that all amounts deferred under a NDCP for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements are met. This rule generally applies to existing deferred amounts "earned and vested" after December 31, 2004.

If a NDCP violates any of Code Section 409A's requirements, all vested amounts of deferred compensation will be currently taxable. The amount also is subject to interest and an additional income tax, equal to the Internal Revenue Service ("IRS") underpayment rate - currently 6 percent - plus 1 percentage point, measured from the date of the deferral or, if later, the vesting date. There also is an additional penalty equal to 20 percent of the compensation required to be included in gross income.

On December 20, 2004, the Treasury Department and the IRS issued Notice 2005-1 ("Notice") to provide interim guidance regarding AJCA. The IRS also indicated that this Notice is the first of a series and more guidance is expected later this summer.


NDCP Subject to 409A. Code Section 409A defines a NDCP as any plan that provides for the deferral of compensation with certain exceptions for tax-qualified plans and welfare plans. Based on the definition, Code Section 409A is applicable to a broad array of nonqualified deferred compensation plans, including nonqualified elective deferral arrangements, supplemental executive retirement plans, 457(f) plans, certain stock appreciation rights ("SARs"), phantom stock plans, discounted stock options, certain severance plans, and certain stock option deferral arrangements.

Short-Term Deferrals. If a plan requires that amounts be paid within a short period after becoming earned and vested, the plan would not be subject to Code Section 409A. The payment must be made no later than two and a half months from the end of the employee's or the employer's taxable year. This exception essentially exempts many bonus plans from AJCA's requirements. Furthermore, if the bonus plan requires participants to be employed on the day the bonus is paid, then the bonus plan is excluded from Code Section 409's scope even if the payments are made more than two and a half months after the performance period. If the employee has the right to the bonus payment at the end of the year and is not required to be employed at the time of payment, then the bonus plan would not be treated as a nonqualified deferred compensation plan as long as payments are made within the two-and-a-half month period.

Exceptions for Certain Equity Compensation. Incentive stock options described in Code Section 422, employee stock purchase plans described in Code Section 423, and restricted stock will not constitute NDCPs. Nonqualified stock options will also be excluded from Code Section 409A if (1) the exercise price is not less than the fair market value of the stock on the date the option is granted, (2) the award is subject to Code Section 83, and (3) the plan does not contain an additional deferral feature other than the delay of taxation until the option is exercised.

SARs can yield economically equivalent results to nonqualified stock options exercised in a cashless transaction, and many commentators have requested that SARs be treated similarly. However, the Treasury Dept. and the IRS are concerned that a general exception for SARs may be exploited as a method to avoid the application of Code Section 409A, particularly in regard to valuation of the underlying stock where the value is not established by and in an established securities market.

Accordingly, the Notice provides limited exceptions for SARs granted by public companies that do not present potential for abuse. To be excluded from Code Section 409A coverage, SARs must meet the requirements applicable to nonqualified stock option plans and can only be settled in stock. For SARs granted by private companies or settled in cash pursuant to a plan in effect on or before October 3, 2004, Code Section 409A is inapplicable as long as the requirements described in (1) and (3) are met with respect to such SAR. Finally, SARs not otherwise meeting the criteria for these exemptions will meet the requirements of Code Section 409A if they have a fixed payment date.

Deferral Elections and Bonus Compensation. Elections to defer compensation must generally be made in the taxable year prior to the taxable year in which the compensation is earned. There is a limited exception for performance-based compensation payable over a period of at least 12 months where the election must be made at least six months prior to the end of the performance period. The Notice provides that this rule is applicable to compensation where (1) the payment of the compensation is contingent on the satisfaction of organizational or individual performance criteria, and (2) such criteria are not substantially certain to be met at the time the deferral election is made.

Subsequent Elections: A plan can allow participants to make subsequent elections to delay payments or to change the form of payments, but such subsequent elections must meet the following criteria: (1) the second election may not be given effect for 12 months after the election is made, (2) except in the case of elections related to distributions on death, disability or unforeseeable emergency, the payments are deferred for an additional period of at least five years, and (3) if related to payments at a specified time or pursuant to a fixed schedule, the second election must be made at least 12 months before the originally scheduled payment date.

Right to Cancel Deferrals. Any plan adopted before December 31, 2005, may be amended to allow a participant to terminate or cancel a deferral election with regard to amounts deferred that are subject to AJCA. Amendments relating to the termination or cancellation of a deferral must be made by December 31, 2005, and such amounts must be included in income for the year of cancellation.

Distribution Restrictions. Payments under a NCDP cannot be distributed any earlier than upon a participant's separation from service, disability, death, a specified time or pursuant to a fixed schedule specified under the arrangement as of the date of the deferral, following a change in control of the corporation to the extent permitted by the Treasury, or the occurrence of an unforeseeable emergency.

Acceleration of NDCP Payments. The acceleration of payments before the specified time or schedule chosen at the time of deferral is prohibited which would eliminate the use of "haircut provisions." The following acceleration events are exceptions to this rule: (1) due to a waiver or acceleration of a substantial risk of forfeiture by the employer, (2) due to a domestic relations order, (3) in order to comply with a federal conflict of interest restriction, (4) a provision to pay taxes upon vesting under a Code Section 457(f) plan, (5) a provision to cash out a minimum specified amount if the payment terminates the participant's interest in the plan, the payment is made on or before the later of December 31 of the calendar year in which the participant separates from service or two and a half months after the separation from service and the amount is not greater than $10,000 and (6) the use of an employee's interest in a NDCP to meet a withholding obligation for an employee's share of taxes.

Offshore Arrangements. If amounts are held in trust (or other arrangements identified by the Treasury Department) outside of the United States to secure deferred compensation obligations, such amounts become taxable (and subject to penalties) once they are set aside. This rule appears to be effective as of January 1, 2005, whether or not the deferred compensation obligations relate to amounts earned and vested after December 31, 2004. Subject to any future regulations to the contrary, offshore deferred compensation plans should not violate AJCA's funding rules if the assets are not set aside from the general assets of the plan sponsor. This is especially true when the assets involved are held in the United States. However, if this interpretation turns out not to be the case upon the release of subsequent guidance, AJCA could effectively terminate all offshore deferred compensation arrangements, including with respect to amounts deferred prior to December 31, 2004.

Plan Amendments. The Notice provides that non-conforming plans do need to be amended by December 31, 2005, provided that the plan is operated in good faith compliance with AJCA during 2005. A number of commentators have asked the Treasury and IRS to postpone this deadline and it is conceivable that such a request may be granted. But until the IRS makes such a determination, the necessary steps should be taken so that any required amendments can be adopted by the plan sponsor's board of directors by the end of the year.

Effective Date. AJCA applies to amounts deferred after December 31, 2004, and amounts deferred in taxable years beginning before January 1, 2005, for plans materially modified after October 3, 2004. The Notice clarifies that an amount is considered deferred before January 1, 2005, if the service provider has a legally binding right to be paid the amount and the right to the amount is earned and vested. In general, a modification of a plan is material if a right or benefit that existed as of October 3, 2004, is enhanced or a new benefit or right is added. Prior to amending any existing arrangement, a plan sponsor must understand the implications of making amounts subject to AJCA.

Informational Reporting. Effective for amounts deferred in calendar years beginning after December 31, 2004, if a Form 1099-MISC or W-2 is required to be filed by a service recipient, it must reflect the amount of deferred compensation for such year regardless of whether it is includible in income. This requirement also applies to any notional income on such amounts.

In light of the enactment of these changes, plan sponsors should consider reviewing their existing NDCPs to determine if any changes will be needed to comply with the new rules.

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