The U.S. Senate today approved the Conference Report on FSC-ETI (H.R. 4520), which contains broad non-qualified deferred compensation reform. This version of the bill was approved by the House last week and will now go to the President for signature. It is expected that the President will sign the bill into law, although the White House has not yet announced the date for a signing ceremony. The new law is generally effective for compensation deferred or vested after December 31, 2004. In light of the massive and somewhat uncertain aspects of these new deferred compensation rules, employers may want to consider a series of action steps in the immediate future. These steps, should include the following:
1. Determine What Plans are Subject to the New Rules. Because the coverage of Section 409A is extremely broad, employers will have to determine which of their plans are subject to the new rules. This will include not only any elective deferred compensation plans but any supplemental executive retirement plan (“SERP”) even though not elective, any individualized deferred compensation even if it only provides for deferred compensation in the executive’s employment contract, bonus plans which include deferral options, stock option plans that have an exercise price that was below the fair market value at the time it was granted, stock appreciation rights, phantom stock and anything that defers the receipt of compensation. For tax-exempt employers, this would include a Section 457(f) plan.
New Section 409A applies to any “plan,” “agreement,” or “arrangement” that provides for deferral of compensation, other than tax-qualified plans and tax-deferred annuities, IRAs, SEPs, SIMPLEs, 457(b) plans, and plans providing for vacation, sick leave, disability, compensatory time, and death payments. Section 409A is not limited to elective non-qualified deferred compensation arrangements. It does not apply to stock options provided that the exercise price is not less than the fair market value of the shares on the date of grant (discounted stock options) and the option does not include a deferral feature beyond the right to exercise in the future (deferred option gains). The provisions apply to stock appreciation rights (SARs) and supplemental nonelective pensions (SERPs), but the conference agreement gives Treasury the authority to issue regulations relating to SARs and changes in benefits forms under SERPs. It is expected that Treasury will apply Section 409A to discounted stock options, but not to employee stock purchase plans under Code section 423(b). The conference report states that the new rules are not intended to apply to annual bonuses or other amounts payable within 2½ months after the close of the taxable year in which the relevant services were performed. However, to the extent that a voluntary deferred compensation plan allows for the deferral of bonus amounts, it may be necessary to make sure bonus plans comply with the preexisting performance based requirements to enable the deferral of bonuses 6 months before completion of the performance period.
2. Determine How New Rules Apply to Those Plans. Employers will need to determine in what respect their existing plans do not comply with the new rules and determine whether there is an advantage to preserving the current plan in grandfathered status or whether it is preferable to give up any grandfathered status and amend the plan to comply with current law. The primary areas of change include:
a) Timing of Deferrals. New Section 409A generally requires deferral elections to be made prior to the taxable year in which the services are performed or as provided in regulations. A special 30-day grace period is provided for new participants in deferred compensation plans. For “performance-based compensation” where the performance period is 12 months or more, elections to defer may be made up to 6 months prior to the end of the services period. The conference report states it is intended that the term “performance-based compensation” will be defined by Treasury to include compensation to the extent that an amount is (i) “variable and contingent on the satisfaction of pre-established organizational or individual performance criteria” in writing within 90 days after the beginning of the performance period and (ii) “not readily ascertainable” at the time of the election. It also is intended that “performance-based compensation” may be required to meet some, but not all, of the Section 162(m) standards, and Treasury has suggested that performance criteria may be subjective.
b) Payout Terms Including “Second Elections.” Distributions are allowed under Section 409A only upon separation from service (as determined by Treasury), death, disability, a specified date (but not event) or pursuant to a fixed schedule, a change in control (to the extent provided by Treasury), or the occurrence of an unforeseeable financial emergency. Aggregation rules apply; for example, a distribution event will not occur a if a participant separates from service from one member of a controlled group, but continues employment with another member of the same controlled group. No accelerations are permitted except as provided in Treasury regulations. Thus, no penalty or “haircut”) provisions will be allowed. Plans may provide that minimal amounts may be automatically distributed upon a permissible distribution event for administrative convenience. Section 409A allows only very limited “second election” to delay, or change the form of, but not to accelerate, a payout provided that the change in election is made at least 12 months prior to the scheduled payout date, does not take effect until 12 months after the date of the election, and results in an additional deferral of at least five years (except in the case of death, disability, or unforeseeable emergency). There is no requirement that the second election be made prior to a termination of employment. It is expected that Treasury will issue regulations regarding the extent to which changes in a stream of payments are permissible. In addition, any “key employee” of a publicly held company would be required to wait 6 months for the commencement of any payment triggered by a separation from service or death. For these purposes, a key employee is defined under Section 416(i) as a top-50 officer with compensation in excess of $130,000, a 5-percent owner, or a 1-percent owner with compensation in excess of $150,000. This definition likely encompasses a broader group of officers than the definition of a Rule 16 insider for purposes of the Securities and Exchange Act.
c) Creditor Access and “Rabbi”Trusts. New Section 409A provides that a transfer of property under Section 83 occurs and employees will be subject to current taxation on benefits as of the earlier of the date that the plan first provides that assets will become restricted to the provision of benefits under the plan in connection with a “change in the employer’s financial health” or the date on which assets are so restricted. The conference report states that this provision will apply in the case of a plan that provides that a rabbi trust will become funded to the extent of all deferrals upon a change in the employer’s financial health even if the rabbi trust is available to creditors. The provision is not intended to apply when assets are restricted for a reason other than change in financial health (e.g., upon a change in control) or if assets are periodically restricted under a structured schedule and scheduled restrictions happen to coincide with a change in financial status. Transfers to foreign rabbi trusts and similar arrangements will be taxable under Section 409A, subject to the Treasury’s authority to write exceptions.
d) Last Minute 2004 Elections or Changes Not Effective. The Amounts deferred in taxable years beginning before January 1, 2005, are subject to the new rules if the plan under which the deferral is made is materially modified after October 3, 2004. The addition of any benefit, right or feature is a material modification. The exercise or reduction of an existing benefit, right, or feature is not a material modification. For example, an amendment to a plan on November 1, 2004, to add a provision that distributions may be allowed upon request if participants are required to forfeit 10 percent of the amount of the distribution (i.e., a “haircut”) would be a material modification to the plan so that the rules of the provision would apply to the plan. Similarly, accelerating vesting under a plan after October 3, 2004, would be a material modification. Amending a plan to remove a distribution provision (e.g., to remove a “haircut”) would not be considered a material modification. Presumably discretionary employer contribution may still be made to a plan that allowed for discretionary employer contributions prior to October 31, 2004.
3. Determine How to Proceed. If there is a desire to retain coverage under existing rules for existing arrangements, it will most likely be necessary to freeze the existing plan and create a new plan for future deferrals. Separating the grandfathered plan from any new deferral plans may be advisable because of concerns about making material modifications in the old plan and because it will likely be necessary to separate the funds in the old plan from the new plan for accounting purposes anyway because of the differences in the rules applicable to those amounts. While this is not a necessary requirement, it is one that may be appealing to employers. Employers should consider taking prompt action to begin drafting new plans (or modifying existing plans) in compliance with the new rules, as well as freezing existing plans. Before taking any final action, however, employers need to evaluate whether such action might constitute a "material modification" that would adversely affect a plan's grandfathered status. Also, employers may want to wait for at least the initial IRS guidance in order to better evaluate their options. Given the short period of time that will be available to bring plans into compliance with these new rules, however, employers may want to begin (at least on a preliminary basis) this process soon while keeping in mind the foregoing concerns.
4. Communicate with Employees. The adverse tax consequences imposed by the statute impact the employee (or independent contractor) who has utilized the deferred compensation arrangement. Typically these programs are bilateral arrangements so that the employer may not have the unfettered right to make changes without the employees consent, at least with respect to amounts already deferred. Employers may want to communicate to their executives promptly the gravity and nature of the changes that will be confronted because executives will need to understand that the rules are changing significantly and will have to make decisions about whether they wish to continue deferred compensation arrangements or not.
We would be happy to help you evaluate the impact of these changes on your executive compensation arrangements. If you would like us to do so or have further questions, please contact either Jay Fenster at (212) 407-4902 or Marla Aspinwall at (310) 282-2377.
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