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The Treasury Department and IRS issued Notice 2005-1 yesterday which provides guidance regarding transition rules under IRC Section 409A, recently enacted in the American Jobs Creation Act of 2004, providing new rules for nonqualified deferred compensation plans. Section 409A provides that unless specified requirements are met, all amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income, to the extent not subject to a substantial risk of forfeiture, including interest from the later of deferral or vesting plus a 20% excise tax.
Transition Rules: The interim guidance on the new deferred compensation legislation, is mostly focused on transition rules and transition relief for 2005. Overall the transitional rules are very generous and give employers until December 31, 2005 to bring plans into compliance with the new rules. More detailed guidance is expected toward the middle of next year.
Restructuring Payout Elections: With respect to amounts subject to 409A or prior deferrals being brought into compliance with the new 409A rules, plans may be amended to provide for new payment elections with respect to amounts deferred prior to the election and the election will not be treated as a change in the form and timing of a payment under A7 409A provided that the plan is amended and the participant makes the election on or before December 31, 2005. Similar rules apply to amending stock option and appreciation rights plans to comply with the new rules. Thus, employers may restructure plans and give employees the right to make new payout elections with respect to existing account balances under the new structure at any time on or before December 31, 2005.
Restructuring Deferral Elections: The guidance allows deferral elections to be made or amended under 409A with regard to services performed on or before December 31, 2005 at any time on or before March 15, 2005, provided that (a) the amounts have not been paid or become payable before the election and (b) the plan under which the deferral is made was in existence on or before December 31, 2004, and (c) the elections to defer are made in accordance with the terms of the plan in effect on December 31, 2005, and (d) the plan is otherwise operated in compliance with 409A. The intent is to give participants another two and BD months to make deferral elections for 2005 salary and 2004 bonuses payable in 2005 (as long as they do not become payable until after the election) as well as 2005 bonuses payable in 2006. Note that, to benefit from the additional 2BD months the plan needs to be in existence on December 31, 2004.
Interim Performance Bonus Definition: A flexible interim definition of “performance bonus” is provided which includes both subjective and objective standards based on many kinds of participant and/or employer or business unit performance measures. The only real limits the guidance includes are (a) the bonus may not be based solely on performance of stock or value of the employer, (b) subjective criteria may not be based on the decision of the participant or a family member. Note that no mention is made of the requirement that performance measures be in writing within the first 90 days of the beginning performance period, thus, care should be taken to comply with this requirement included in the original legislative discussion during the first quarter of next year, as well as the requirement that the performance period be at least 12 months long. If these requirements are met, bonus elections for a calendar year 2005 performance period may be made as late as June 31, 2005.
Grandfathering Rules: The new rules apply to amounts vested or deferred in taxable years beginning after December 31, 2004. With respect to amounts earned in 2004 and payable in 2005 the guidance provides that such amounts will be considered deferred before January 1, 2005 if by December 31, (i) the participant has a legally binding right to be paid the amount and (ii) the right to the amount is earned and vested. Thus, 2004 bonuses payable in 2005 may only go into a grandfathered plan and not be subject to the new rules if amounts are deferred and fully vested as of December 31, 2004. It is not clear to what extent such amounts must be determined as of the end of the year, particularly if they are based on subjective criteria or whether subjective criteria may prevent there from being a clear legal obligation as of December 31, 2004.
Material Modifications: The guidance provides that it is not a material modification for a participant to exercise discretion over the time and manner of payment of a benefit to the extent such discretion is provided under the terms of the plan as of October 3, 2004. Thus, “hair cut” acceleration provisions should still work in a grandfathered plan. Also, it is not a material modification to change a notional investment measure to, or to add, an investment measure that qualifies as a predetermined actual investment within the meaning of social security tax regulations. The amendment of a plan to bring the plan into compliance with the provisions of A7 409A will not be treated as a material modification. Amending an arrangement on or before December 31, 2005 to terminate the arrangement and distribute the amounts of deferred compensation thereunder will not be treated as a material modification, provided that all amounts deferred under the plan are included in income in the taxable year in which the termination occurs. Such termination and liquidation may apply to some or all participants and may be at the discretion of either the employer or the participant. Treasury officials acknowledge that this represents a temporary exception to the normal rules of constructive receipt.
Change in Control Provisions: The guidance allows acceleration of payments on a change in control of the employer (or parent entity) and includes a fairly broad majority (50%) change of control provision. It is clear that acceleration may be automatic under the terms of the plan or at the discretion of the employer but it is not clear whether or to what extent the employee may be given discretion to elect to accelerate distribution at or around the time of the change in control.
Definition of “Substantial Risk of Forfeiture”: The notice includes a new and interesting definition of “substantial risk of forfeiture” which disregards agreements to delay or roll vesting after services have been performed and agreements to refrain from performing services.
Definition of “Deferred Compensation”: The Notice indicates that the new legislation applies to any compensation arrangement in which payment of a legally binding right is deferred until a later year. If payment is subject to a unilateral right of reduction, then (unless that reduction is not likely to be exercised) no deferral has occurred. Further, if the deferred amounts are subject to future vesting requirements and payment is made reasonably promptly after vesting,i.e., within 2BD months after the tax year in which the vesting occurs, then (at least for the time being) those amounts are not subject to section 409A. If, however, the employee or other service-provider has an election to delay payment to a later year, then the amount will constitute a statutorily encompassed nonqualified deferred compensation arrangement.
Bonus Plans: Bonus plans are not subject to section 409A if they are paid within 2BD months after the later of the employer’s (or service-recipient’s) fiscal year or the employee’s (or service-provider’s) taxable year, so long as elections to delay payment are not permitted.
Equity Plans: The legislation clarifies that restricted stock or other restricted property is not, in and of itself, a nonqualified deferred compensation arrangement subject to the legislation. However, restricted stock units, i.e., promises to transfer property in the future are subject to section 409A. Significant relief is provided for stock appreciation rights (SARs) as well. If the SAR, which relates to employer stock that is traded on an established securities market, is settled only in that employer stock and does not contain any other deferral features, then that SAR arrangement will not be subject to section 409A. Also, cash-settled SARs that are otherwise grandfathered may also be excluded from section 409A if they do not contain any other deferral features.
Reporting Requirements: The Notice requires compliance with the requirement that deferred compensation subject to the new rules to be separately reported on W-2 or 1099 (Misc) as soon as such amounts are reasonably ascertainable regardless, of whether they are includible in taxable income for such year.
The Internal Revenue Service intends this guidance to last until it issues proposed or temporary regulations, which it expects to do sometime in the first half of 2005. For now this guidance will constitute the major regulatory assistance in dealing with issues concerning nonqualified deferred compensation arrangements.
This client alert is a publication of Loeb & Loeb and is intended to provide information on recent legal developments. This client alert does not create or continue an attorney client relationship nor should it be construed as legal advice or an opinion on specific situations. We will continue to monitor and keep you informed of further developments regarding this legislation. If you have further questions please e-mail or call Marla Aspinwall at (310) 282-2377.
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