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:

• elective salary deferral arrangements;

• supplemental executive retirement plans (SERPs);

• bonus deferral arrangements (mandatory and elective);

• phantom stock plans;

• restricted stock units;

• stock appreciation rights (SARs);

• deferred compensation plans for directors and other independent contractors; and

• Section 457(f) "ineligible" deferred compensation plans of tax-exempt organizations and governmental units.

The new rules specifically exempt the following arrangements from coverage under the Act:

• tax qualified retirement plans (e.g., 401(k) and pension plans);

• 457(b) "eligible" deferred compensation plans of tax-exempt organizations and governmental units;

• tax deferred annuity plans and contracts under Sections 403(a) and (b);

• SEPs;

• SIMPLE IRAs;

• vacation leave;

• sick leave; and

• disability pay.

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:

• Initial deferral elections generally must be made before the tax year in which the services giving rise to the compensation are performed. An exception applies to newly eligible employees who may make elections within 30 days of when they first become eligible to participate under the plan.

• Under performance based compensation arrangements (where the performance period is at least 12 months) the initial election must be made at least 6 months before the end of the performance period.

• Nonqualified deferred compensation arrangements may permit a subsequent deferral election to delay payment or change the form of payment provided that such election may not take effect until at least 12 months after the date of the election, the subsequent election is made at least 12 months before the originally scheduled payout date and payments are deferred for an additional period of at least 5 years.

B. Distribution Requirements

Under the new rules, a nonqualified deferred compensation plan must provide that compensation deferred may not be distributed earlier than:

• Separation from service, as determined under Treasury regulations, subject to a 6 month post termination waiting period for certain "key employees" of public companies (officers who have annual compensation in excess of $130.000 (limited to the top 50), 5% owners and 1% owners earning more than $150.000). Control group concepts will be applicable, so that termination from a company and continued service for a member of the control group will not be an eligible distribution event;

• disability;

• death;

• a specific time or pursuant to a fixed schedule specified under the plan at the time of the initial compensation;

• a change in control of the corporation or a change in a substantial portion of the assets of the corporation, to the extent permitted by Treasury regulations. Treasury is directed to issue such regulations within 90 days after enactment of the legislation; or

• an unforeseeable financial emergency. The amount of the distribution must be limited to the amount needed to satisfy the emergency and may include amounts needed to pay resulting taxes.

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:

• Inventory all plans and arrangements affected by the Act. As noted above, in addition to classic deferred cash compensation arrangements, the Act appears to cover equity based compensation plans, phantom stock plans, restricted stock units, SARs, SERPs and other similar arrangements.

• Inventory all outstanding, unvested awards under current plans and arrangements to determine the potential impact of the grandfather provisions (which will have to be reviewed once the regulations governing transitional arrangements are issued).

• Evaluate and prepare to comply with the Act. This will include preparation for amending current plans (although no actual amendments should be adopted before further guidance is issued), drafting and adopting new arrangements, communicating the new rules to participants and updating securities law disclosure to reflect the new rules (e.g., S-8 prospectuses). For listed companies, Board compensation committees will need to be briefed on the new requirements and consider how changes in compensation arrangements necessary to avoid the Act's penalties fit into the company's overall compensation policies and philosophy, so as to be able to address such matters in their annual reports on executive compensation required by the SEC's proxy rules. For listed companies, consideration will also be required of the need for stockholder approval of amendments to equity-based compensation plans (to the extent the Exchanges and Nasdaq consider such amendments material changes).

• With respect to 2004 annual bonuses that are payable in 2005 and are subject to the new rules, it appears that employers should proceed with collecting deferral elections before the end of the year if this has not already been done. It may be prudent to inform participants that these deferrals will be subject to the new rules and that they will have the opportunity to unwind their elections at a later time in accordance with procedures to be issued by the Treasury.